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Putting PFG In Perspective

By Mark Melin

As the reign of the Wassendorf family, one of the few remaining family-run futures commission merchants (FCMs) ends in fraud, with $215 million of customer money missing, stolen over a 20 year period of time, many inside the commodities industry look at the situation with bewilderment.

Such confusion stems not from the fact the firm had failed. Rumors as to PFG's failure grew to a dull roar in fall of 2011, just as MF Global was entering into its freefall. It is how the firm failed - through a 20 year history of fraud - that shocked many knowledgeable industry participants.

Wassendorf: A Big Spender to Promote the Industry

To outsiders, the lavish spending of Russ Wasendorf Sr. on a private plane, exotic trips with staff and a castle of a corporate headquarters amidst the corn fields of eastern Iowa might have been reason to question the firm's capital sources. However, such spending habits were not entirely uncommon among Chicago commodity traders and FCM presidents. Executives at Alaron Trading, a firm PFG acquired, were known to enjoy the convenience of private planes as they attended Super Bowl events or visited their ski retreats or winter homes in warmer climates. In fact it is ironic that Mr. Wasendorf attempted suicide outside the company headquarters in an Oldsmobile, a middle class American brand as clear as those values the futures executive and his politically and socially conservative principals attempted to project. Mr. Wasendorff was a conspicuous giver to various charities and was known to treat his employees generally well, although PFG had gone through a series of pay cuts as the firm suffered from a zero interest rate environment. Typically a retail - focused firm such as PFG would rely on interest income earned from customer margin deposits to generate approximately 30% of the revenue. (Interest income among FCMs focused on the institutional market is much a lower percentage.)

One reason it was difficult to determine the health of Mr. Wasendorf's empire was due to its diversity and lack of public disclosure. News reports have since surfaced that pegs two losing years for the firm at near $500,000 each year, a drop in the bucket relative to $215 million missing.

The Wassendorf mini-empire included the flagship futures brokerage, the largest component, an industry magazine that, towards the last year while still in print, was speculated to have been bleeding near $75,000 to $100,000 per month while generating sales leads for the futures brokerage; a high-end restaurant in Iowa, where employees earned relatively significant wages and benefits but where prices for the premium dining experience were reasonable; an advertising agency and a book publishing business; a once highly profitable construction company in Europe that is now said to be struggling to survive.

PFG sponsored the CTA Challenge, a public competition that gave emerging managers a chance to trade professionally. The winner of the competition, with the highest returns, traded $1 million of what was then assumed "Russ Wasnedorf's capital." Because the winner was based on highest returns, often times the winners of the competition were significantly volatile investments. In a case of sell near a high, the often times volatile traders had one great year when they won the competition, but the subsequent year might have learned the lesson that downside deviation was more than an academic concept. It might be observed that the middle of the pack is where the consistent single digit performers could be found - the real stars of managed futures.

Mr. Wasendorf had built a reputation as an FCM CEO who supported the industry in which he operated, sometimes in lavish fashion. For instance, he is said to have spent $400,000 of firm capital to lure former US president George W. Bush and his wife Laura to speak at the CMEGroup's leadership speaker series, one of many such speakers he is said to have entirely underwrote. Even with this spending, it seems difficult to account for average spending of over $10 million per year in stolen money ($215 million missing over a 20 year period).

While he spent lavishly to ensure his position as an industry leader, his acquisitions of competing FCMs were generally considered prudent but are now being questioned for their true motivation. For instance, their 2007 of American National Trading Corporation (ANCO) in west Los Angeles was hailed at the time for bringing aboard a managed futures division that had penetrated the ranks of certain equity-based financial advisory firms, assisting them in helping offer a direct managed futures account alongside equity offerings. Contrast this to the Chicago-based managed futures division primarily supported introducing brokers (IBs) and had grown to become a powerful force among FCMs who offered retail-focused IBs tools to power managed futures portfolio development needs. In hindsight, some industry participants now speculate that Mr. Wasendorf's acquisitions might have been less about acquiring strategic assets and more about providing new and needed capital to propel his deception. In the American National acquisition, PFG is said to have acquired close to $50 million in customer AUM and the Alaron acquisition is said to have added just near $100 million.

The majority of PFG's asset base, reported in excess of $400 million, is said to have primarily come from introducing brokers. PFG was best known as a service firm to such introducing brokers, with various divisions in the company using this distribution channel for their products. One industry leading managed futures IIBs, for instance, is said to be the firm with among the largest PFG exposure, upwards of $50 million by some estimates.

While many of the firm's divisions were said to be self sufficient to various degrees, and a few of the divisions operated under water, the "cash cow" was said to be the foreign exchange (FX) division, located in New York with participants in Chicago. Trouble started to bubble to the surface on a regulatory front, and PFG was required to pay a $700,000 fine on FX business related to the Chicago office. Some close to PFG were said to question the wisdom of the president not distancing himself from the situation. It is for this reason when PFG encountered another significant regulatory / legal issue with Trevor Cook, an FX fund involved in a Ponzi scheme, certain industry participants begin to watch closely. PFG's FX division cleared trades for the fund. When pending court action that some said could sink the firm, some industry participants began to speculate as to PFG's solvency, voices of which grew louder moving into 2012. While some PFG employees proclaimed the firm's innocence in the fall of 2011, industry participants began speculating it would likely only be a series of PFG legal maneuvers that could provide the firm oxygen for three to five years. Some industry participants speculated that ultimately the firm's demise was just a matter of time. It was this issue that had been assumed to be the likely source of the firm's ultimate demise, not fraud.

Where the Debt Crisis Leads

By Mark Melin

Speculation is that a small group of US economic and political leaders on both sides of the political isle now recognize the devastating nature of the US debt crisis issue and are working to solve the problem behind the scenes. Professional investors should keep eyes on these negotiations, as certain participants inside the yield curve will watch for potential for compromise to solve a crisis.

Here is the problem in a nutshell. The US government's current expenditures are nearly double revenues. That can't last forever, much like the Federal Reserve purchasing 60% to 70% of the bond float won't last. At some point the endless excess spending without foundation will be forced to end. If not addressed, the problem could lead to a market / government collapse the extent of which has never before been witnessed. This has potential to be worse than 1933 Germany, which experienced a dramatic drop in value of its currency and ushered in Adolph Hitler. The structural difference between 1933 Germany and today is that today's western economies and banking systems are interconnected as never before.

"The structural difference between 1933 Germany and today's western economies is that so many of the western economies and banking systems are interconnected as never before."

Society's margin call could be upon us in three to five years, which it turns out might be a conservative estimate. In fact, well-known author Peter Schiff recently predicted a market crash in 2013 or 2014. Professional investors are likely aware that he predicted the 2008 housing bubble before it occurred. This wasn't as much as crystal ball as much as it was understanding the math.

The question is will that force be one massive, abrupt market shock so debilitating that it would likely result in societal change? Or does the government work to address the need to balance a budget in a more logical fashion, gently easing off gas, slowing the massive borrowing from the future to pay for the present?

If government is serious, the question becomes when do you pull the trigger, take your medicine and solve the problem? And that problem is significant when one considers the solution may require voter sacrifice. That's a real problem.

The majority of those in the workforce today have never witnessed the need for societal sacrifice as was witnessed during the great depression or World War II. We are entering a period of time where the workforce has more seniors to support than at any point in history, as Bloomberg's Scarlet Fu pointed out recently. If the fact more seniors were going to be retiring shortly wasn't enough, add in the fact healthcare is at its most costly point in history and that interest rates will likely rise over the next three to five years - all draining a budget that was drained from the start. Social Security, upon which seniors assumed was being deposited in safe keeping, has been spent.

Voters are going to be the problem. Like Pavlov's dog they are conditioned expect painless solutions, government "stimulus" and related faux "growth" to solve all ills. As author John Mauldin points out, this time there are no easy answers to solve this problem. It requires sacrifice. However, a politician advocating sacrifice is a politician out of work. This is a tricky situation given the fact that as government becomes increasingly over-leveraged its bag of tricks becomes more of a trick than a treat, bringing the government closer to the ultimate margin call.

To solve the problem, government must both expand its revenue base and reduce spending, which is the conclusion of think tanks on both the right and left. The alternative is to continue kicking the can, except the math says the can kicking will end shortly. The problem is if the debt crisis ends in a crash, that crash could be the most significant in history. It is for this reason that a rare few responsible political leaders on both sides of the isle are talking solutions. Watch for the real discussions to emerge after the election, as the "fiscal cliff" approaches. The solution will require compromise on both sides of the political spectrum. Republicans will be required to offer new revenues and Democrats will be required to offer up painful budget cuts. On the Republican side, watch for solutions to involve changes to the tax code structure to improve revenues without "technically" raising taxes. Democrats, for their part, offered significant cuts in the 2011 debt ceiling debate. Watch this situation because a breakdown in negotiations could indicate significant structural problems ahead.

The US is a government that has almost twice the debt per citizen as Greece and needs to recognize that its margin call isn't that far off. It's time for logical people to embrace what might be difficult solutions in order to preserve the future. This is no longer "our children's problem," but our generation's problem.