When MF Global filed for bankruptcy protection in August 2011, voices in the media wondered aloud why regulators could not successfully monitor the excessive risk undertaken or why a bailout from the U.S. government wasn’t forthcoming.
A year after MF Global’s bankruptcy, another financial firm, Knight Capital, was near collapse. Though Knight was a broker-dealer much smaller than MF Global and in a different business from MF Global, Knight was the largest handler of stock orders for U.S. retail brokerages. Its case serves as an interesting counterpoint to the bankruptcy of MF Global, as well as the events of the fall of 2008.
What happened to Knight may sound like a scene from a bad movie. Due to a computer glitch, the firm bought $5 billion of stock in a trade that was intended to take place over five weeks but was executed in just 20 minutes. The firm subsequently disclosed a $440 million pretax loss due to this malfunction, while its market value at its low-point after the erroneous trade disclosed was just $250 million. Knight share price plummeted from around $12 in late July 2011 to around $2.50 in mid August of that year.
Thus, in a matter of a few minutes, a firm that had been reasonably healthy came close to collapse.
To avert bankruptcy, the firm desperately attempted to sell itself to other broker-dealers. These deals fell through, as other firms were reluctant to take on the suddenly-troubled broker-dealer.
Ultimately, Knight secured about $400 million over a weekend from a few investors led by Jefferies. In turn, Knight issued convertible securities, which are bonds that will turn into equity in the firm in the future.
The part of the story that is worth highlighting is the tenor of the response within the financial community to Knight’s predicament. While other firms, competitors and clients alike, expectedly based their business decisions in part on the familiar rationale of cost-benefit analysis of the competitive landscape, they also reached out to Knight in attempt to help save the firm. CEO Thomas Joyce said, in a live interview, "The wildly flattering thing was how our clients responded to us...when we were under stress last week."
It appears that there was willingness on the part of Knight’s counterparties to step in to Knight’s rescue, partly because of the trust that Knight engendered with its business partners over their years of doing business together. While the firm remains a shadow of its former self, its good business relations stood in its good stead and allowed it to stay afloat. Recently, competitors Getco and Viru have offered to buy the company, albeit at $3.50 a share, a fraction of its value in July 2011.
Shareholder lawsuits have come and will be coming in the future against Knight. It should be noted, however, that Knight shares could easily have been wiped out had Knight not been able to secure bridge funding, leaving shareholders without even the fraction of the value of the firm.
The point of this episode as it relates to our class discussions of bailouts, bankruptcy, and regulators and accounting firms whose job it is to monitor the business practices of other companies, is that trust built over years of doing business can go a long way into solving unexpected and sometimes difficult problems. Knight CEO Thomas Joyce said that the company received some 90 inquires from clients offering to participate in its bridge funding to avert the firm’s collapse. With 90 market participants offering to chip in, there was little need for the U.S. government to contemplate a bailout even if the government was interested in doing so.
There are of course important caveats to generalizing this episode to the bailouts of 2008 and to MF Global. The most obvious one is the small size of Knight Capital compared to the firms involved in those events. But if professionals and laypeople alike had been told about a trading firm experiencing a bankruptcy-threatening computer malfunction, not many would have predicted an outpouring of goodwill towards Knight from its clients. This goodwill would not have been possible had the U.S. government publicly pondered a bailout.