MF Global warning: Financial markets have not been fixed

The October 31 bankruptcy of MF Global Holdings Ltd., a broker-dealer on Fifth Avenue in New York City, is important news for all Americans because it is a warning: The Dodd-Frank Act, which Congress passed 16 months ago to protect Americans from another financial crisis, is not working.

Instead, one thing that does seem to protect Americans is size.

The MF Global bankruptcy was triggered by one of the same key Wall Street gambles that rocked Bear Stearns & Co., Lehman Brothers Holdings and others in 2008 and froze credit markets, that brought Long-Term Capital Management hedge fund to its knees in 1998 and Orange County in 1994, and that threaten European banks today: Repurchase (repo) loans.

These nuclear weapons are still as dangerous as ever.

Yet MF Global’s 2008-style failure – while tragic for its employees (2,894 on September 30), investors, clients, suppliers, and others – is having little impact on Main Street. Why? Mainly because of its size.

Although MF Global is said to be the eighth largest bankruptcy in US history,  it reported only $41 billion in assets, compared for example to Bear Stearns at $399 billion and Lehman at $639 billion.

MF Global’s relatively limited impact is not going unnoticed. In today’s complex financial markets, where reforms take years and even decades to implement, and unintended consequences become the seeds of the next crisis, some experts are falling back on a simplier solution: Just get rid of financial institutions that are Too Big To Fail.

As Federal Reserve Bank of Dallas President Richard Fisher said at Columbia University in New York November 15:

I believe that too-big-to-fail banks are too-dangerous-to-permit.

Although Main Street has hardly noticed the MF Global failure, the bankruptcy has mesmerized Wall Street, in part because it seems to reveal that bankers, dealers and the Federal Reserve haven’t changed much since the calamity of 2008.

-MF Global still used repurchase agreements to finance many of its transactions, in spite of repo danger.

-Major institutions, led by JP Morgan Chase, still loaned MF Global billions of dollars, in spite of the firm’s risky trades.

-The Federal Reserve still gave MF Global the coveted designation of Primary Dealer – by adding the company to the list of banks and broker-dealers authorized to trade with the Fed – even though MF Global was deeply in debt.

MF Global bragged about the Primary Dealer designation in the annual report it filed with the Securities and Exchange Commission May 20:

In February 2011, we were named one of 20 primary dealers to the Federal Reserve Bank of New York:

As one of only 20 firms that have been designated primary dealers, we serve as a counterparty to the Federal Reserve Bank of New York in its open-market operations, participate directly in U.S. Treasury auctions, and provide analysis and market intelligence to the Federal Reserve’s trading desks. This status creates significant benefits for our clients because as a primary dealer we can offer a high level of access to U.S. government securities and related markets, and greater liquidity, broader market insights, and enhanced ease of execution. In addition, we believe the designation enhances our reputation as a valued counterparty.

A risk that still threatens financial markets

The fall of MF Global highlights what some believe is a major threat still facing world financial markets, in spite of Dodd-Frank and similar international reforms.

Economists call this threat liquidity risk – that is, not having, or not being able to get your hands on, enough cash when you need it.

Liquidity risk brought down MF Global.

How? MF Global borrowed on the repurchase market, used that money to buy securities, and put up those securities as the collateral for the repo loans.

Where’s the danger in that?

It’s in the collateral.

If the value of the collateral securities declines, the repo lender can demand more collateral or repayment of part of the loan, long before the loan actually comes due.

Thus, a borrower that will have no trouble repaying the loan when it comes due, yet doesn’t have extra cash in the meantime, can be crushed by a lender’s demands if the value of collateral falls during the life of the loan.

To make matters worse, other trading partners that get wind of this trouble may also start requiring more collateral or repayment, even for transactions where the value of the collateral securities is still strong, because they fear for the survival of  the borrower.

The collateral calls can force the borrower into fire sales of securities to raise money, driving down the value of the securities further, triggering more collateral calls, leading into an accelerating death spiral.

This is not news. It’s exactly what happened on U.S. financial markets in 2007 and 2008, when mortgage securities  were the troubled collateral. It’s a key reason that a crisis in a small corner of the U.S. housing market nearly became an international economic armageddon in 2008.

This wasn’t news to MF Global, either. From the annual report MF Global filed with the Securities and Exchange Commission May 20:

Collateralized financing arrangements used in connection with proprietary activities expose our company to issuer default and liquidity risk.
 
To the extent that we have financed a position through a collateralized financing arrangement with a counterparty (for example, by means of a repurchase transaction), our counterparty will often have the right to require us, at any time during the term of the repurchase agreement, to meet margin calls resulting from decreases in the market value of the collateral that we post for financing. Accordingly, repurchase agreements and other similar financing tools create liquidity risk for us because if the value of the collateral underlying the repurchase agreement decreases, whether because of market conditions or because there are issuer-specific concerns with respect to the collateral, we will be required to post additional margin, which we may not readily have. If the value of the collateral was permanently impaired (for example, if the issuer of the collateral defaults on its obligations), we would be required to repurchase the collateral at full value upon the expiration of the repurchase agreement, causing us to recognize a loss, which could be significant.

The collateral that caused trouble for MF Global was Italian, Spanish, Belgian, Portuguese and Irish sovereign bonds.

In its second-quarter earnings report released October 25, MF Global announced a $186 million quarterly loss. The report showed the company had $39.7 billion in debt, including $17 billion at risk on the repurchase market, and only $1.2 billion in equity.

It also revealed that in the past year MF Global had borrowed on the repurchase market to buy $7.6 billion in Euro bonds, which collateralized the repo loans, and had a net $6.3 billion at risk after hedging.

CEO Jon Corzine said in the earnings announcement:

Over the course of the past year, we have seen opportunities in short-dated European sovereign credit markets and built a fully financed, laddered maturity portfolio that we actively manage. We remain confident that we have the resources and expertise to continue to successfully manage these exposures to what we believe will be a positive conclusion in December 2012.

With trouble engulfing the Eurozone, and the price of sovereign bonds falling, collateral calls loomed. But Corzine told investors in his October 25 earnings conference call that MF Global’s “liquidity position remains strong,” with $3.7 billion in cash or cash-like assets, up 17 percent in three months.

That day MF Global shares fell 47 percent, from $3.55 to $1.86, on a 12-fold jump in volume.

Meanwhile, rating agencies viewed the gamble on European sovereign debt as a sign that MF Global was taking on “substantial risk” in a struggle to be profitable. Two days later, Moody’s Investors Service and Fitch Ratings downgraded MF Global’s credit rating, the second downgrade by Moody’s in three days. From Moody’s October 27 announcement:

Moody’s said the downgrade reflects our view that MF Global’s weak core profitability contributed to it taking on substantial risk in the form of its exposure to European sovereign debt in peripheral countries. At the end of the second quarter, MF Global’s $6.3 billion sovereign risk exposure represented 5 times the company’s tangible common equity, Moody’s noted.

“The tactical decision to assume this outsized proprietary position, highlights the core profitability challenges faced by MF Global and the scope of the re-engineering challenge facing the firm’s management,” said Al Bush, a Moody’s senior analyst.

Four days later MF Global was forced to file bankruptcy.

From a November 1 Financial Times story by Geneva reporter Izabella Kaminska, whose work has led the business press’s coverage of the MF Global collapse:

The trade’s greatest folly was that as the market prices of the bonds fell sharply, it would have to pay higher amounts of collateral, soaking up its liquidity.

Repo-to-maturity

The type of repo that MF Global used had seemed on the surface to be a reasonable investment. Called repo-to-maturity, it was a transaction in which MF Global’s repo loans didn’t come due until the sovereign bond collateral did.

MF Global’s strategy was to pay less interest on the repo loans than it was earning on the bonds – the difference was MF Global’s profit – and when the countries paid off the bonds, MF Global would use that money to pay off the repo loans.

As an added bonus, the bonds were eligible for support from the European Financial Stability Facility, created by the Eurozone countries “to safeguard financial stability in Europe by providing financial assistance to euro area Member States.” This meant MF Global could be pretty sure the countries would be able to meet their bond obligations.

Here’s how MF Global described the deals in its October 25 earnings report:

As of September 30, 2011, MF Global maintained a net long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity (repo-to-maturity), including Belgium, Italy, Spain, Portugal and Ireland. The laddered portfolio has an average weighted maturity of October 2012 and an end date maturity of December 2012, well in advance of the expiration of the European Financial Stability Facility in June 2013.

MF Global said its repo-to-maturity agreements were mainly negotiated with inter-dealer brokers like Tradition, ICAP, Tullet and Garban and with banks such as UBS. 

MF Global accounted for its repo-to-maturity transactions as sales, which meant that MF Global did not include the European bonds with its assets, although it still technically owned them. By “selling” the European bonds, MF Global reduced its assets and, therefore, its leverage, when leverage is defined as comparing assets to equity.

Without the European bonds, MF Global still had a leverage ratio at September 30 of 33:1 (comparing total assets of $41 billion to common equity of $1.23 billion). That was essentially unchanged from a year earlier and similar to the highly critized leverage levels at investment banks in 2008.

MF Global has said its business was to broker commodities and derivatives for clients. Instead, it became a poster child for the danger of liquidity risk on the repurchase market.

Editor’s Note: As a Primary Dealer, MF Global was a participant in the tri-party repurchase market, where JP Morgan Chase and Bank of New York Mellon serve as clearing banks. MF Global complains that JP Morgan was slow to clear its trades in the frantic days leading up to the bankruptcy, when MF Global was trying to respond to collateral calls from counterparties and withdrawal demands from clients. Lehman Brothers, also a Primary Dealer, has sued JP Morgan over similar issues arising out of Lehman’s 2008 bankruptcy.

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The Chapter 7 bankruptcy case is MF Global Inc., 11-02790, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

Further reading: “Nomura Curtails European Debt Dealings” by Michael Rapoport, Wall Street Journal, November 29, 2011.