As noted in this earlier post, an old fashioned run on the bank resulting from a lack of trust in the marketplace — as opposed to losses attributable to a relatively small number of shady business deals — is what really caused the demise of Enron. The revelations over the past week relating to Refco, Inc. — the largest independent futures-brokerage firm in the U.S. — has generated a similar lack of trust in the marketplace that has thrown Refco into its own Enronesque experience.
Although no where near the size of Enron, Refco is still a pretty darn big outfit. It has over $4 billion in approximately 200,000 customer accounts, and Refco’s futures-brokerage business is as big as the derivatives desks of most major Wall Street firms. The company is well-known for trading commodities, currencies, bonds and derivatives transactions with a wide-range of trading partners and counterparties, including hedge funds and customers attempting to hedge risk. Nevertheless, Refco — as with many such trading firms — is highly-leveraged, as its most recent public filings reflect about $75 billion in assets and a roughly equal amount in liabilities.

Refco’s problems began this past Monday when the company put CEO Phillip R. Bennett on indefinite leave after discovering that Summit, N.J. hedge fund, Liberty Corner Capital Strategy helped Mr. Bennettt cover up that he owed Refco $430 million. Mr. Bennett apparently owed the debt to Refco personally, but periodically had arranged for Liberty Corner to confirm the $430 million debt as its own so that Refco could reflect the same on its balance sheet for reporting purposes at the end of several of quarters. Federal prosecutors promptly arrested Mr. Bennett and charged him with fraud in connection with the firm’s IPO.
Although the details of the arrangement remain hazy, for its part, Liberty Corner is contending that it believed that it was simply borrowing from one Refco subsidiary and lending to another Refco sub, and not lending to an entity that Mr. Bennett secretly controlled, as the indictment of Mr. Bennett alleges. For example, one transaction described in the indictment alleges that a Refco subsidiary Refco Capital Markets loaned $335 million to Liberty Corner, which was to be repaid two weeks later just after the end of Refco’s fiscal year. At the same time, Liberty Corner loaned the same amount to Refco Group Holdings Inc., which Mr. Bennett controlled, for the same two-week period at a slightly higher interest rate. Thus, Liberty Corner made an estimated profit of roughly $100,000 on the deal, which apparently was repeated on a number of occasions.
Yesterday, Refco’s crisis deepened as the company shut down one of its key units and the New York Stock Exchange indefinitely halted trading in its stock. Although Refco contends that its core regulated futures trading business remains on solid financial footing, former trading partners and lenders of the firm are fleeing in droves. Inasmuch as Refco relies heavily on borrowed funds to participate in billions of dollars in transactions, even the trading partners and lenders who are hanging in with the company are demanding greater financial assurances before doing deals, which simply diminishes Refco’s ability to sustain profitability all the more.
Refco shares — which have decreased in value by over 60% just since the week began — were at $7.90 when the NYSE halted trading. In the meantime, rating agency Standard & Poor’s downgraded Refco’s long-term counterparty credit rating further into junk status as Refco’s junk-rated bonds were quoted as low as 30 cents on the dollar — a price level associated with distressed companies — and its syndicated bank loans were quoted in the 60s. That does not go over well with institutions that invested in Refco’s debt at par (i.e., 100) or close to that price.
Refco’s board of directors attempted to place a finger in the leaking dike yesterday by hiring former Securities and Exchange Commission Chairman Arthur Levitt and former U.S. Comptroller of the Currency Eugene A. Ludwig to advise its board. However, even with that move, absent a white knight buyer emerging — such as private-equity firm Thomas H. Lee Partners LP (owner of a 38% stake in Refco) — the question increasingly is not whether Refco can avoid filing bankruptcy, but when it is going to file.
Interestingly, one of the lenders that apparently has flown the coop on Refco is American International Group, which had its own Enronesque experience earlier this year.
Finally, the litigation buzzards are circling Refco’s auditor, Grant Thornton LLP. The firm did not catch Mr. Bennett’s alleged scheme with Liberty Corner, although it appears that Liberty Corner advised the auditors that it owed the debts in response to audit confirmation requests that the firm sent out during its audits of Refco. Nevertheless, the Public Company Accounting Oversight Board has already opened an inquiry into Grant Thornton’s audits of Refco.
Welcome to the big leagues of risk relating to audits, Grant Thornton.