In yesterday’s column, I took the time to explain Wall Street’s newest accounting trick – re-hypothecation.
Today, I want to share how it led to the loss of $1.2 billion in customer funds and the ultimate demise of MF Global (Other OTC: MFGLQ.PK). And more importantly, what we should take away from this unfortunate situation…
Greed is Good?
MF Global’s problems didn’t start with re-hypothecation. They started with something much simpler – greed.
The firm wanted to make a bet that eurozone bonds would remain default free. I’ll concede that’s a smart bet, given the formation of the European Financial Stability Facility.
Essentially, MF Global was banking on a European version of “too big too fail” – betting that the indebted eurozone countries were too important to the global economy to let them default.
But a smart bet doesn’t translate into a risk-free bet. And leverage only magnifies risk, which is something MF Global learned the hard way.
You see, MF Global didn’t invest a modest amount in bonds of some of Europe’s most indebted nations (Italy, Spain, Belgium, Portugal and Ireland). It invested $6.3 billion. That’s equal to more than five times the firm’s book value!
Now, you might be asking yourself, how in the world was MF Global able to make such an outsized bet? With off-balance sheet transactions, of course.
(Remember, that’s how Wall Street typically tries concealing its transgressions. Case in point: Enron and special purpose entities.)
In this case, MF Global was specifically using “repurchase and reverse repurchase transactions to maturity” to keep its actions off the balance sheet.
I won’t bog you down with the details of repo-to-maturity trade. Here’s the gist…
MF Global buys a ton of European bonds with high yields maturing in 2012. It then turns around and uses those bonds as collateral to borrow money at very low interest rates.
The way this trade works out is simple…
Until the bonds mature, MF Global earns the spread – the difference between the high interest it receives on the bonds and the low interest rates it pays on the borrowed funds. When the bonds mature, MF Global uses the principal received to pay off its loans. Simple as that.
But it sounds too good to be true, doesn’t it?
Well, it seemed a bit surprising to MF Global’s CEO, Jon Corzine, too. In the firm’s most recent earnings conference call, he said, “The spread between interest earned and the financing cost of the underlying repurchase agreement has often been attractive even as the structure of the transaction themselves essentially eliminates market and financing risk.”
In other words, such risk-free trades shouldn’t exist. And ultimately, they don’t.
Can You Say, “Margin Call?”
The big risk inherent in MF Global’s repo-to-maturity trades was liquidity.
At any point, MF Global’s lenders could require more collateral. And that’s exactly what they did, as the debt crisis in Europe became more uncertain.
The only problem? MF Global didn’t have any cash of its own lying around to meet the margin calls. So it pledged its customers’ funds – via re-hypothecation – as additional collateral.
The straw that broke the proverbial camel’s back came from the New York Fed.
Earlier in the year, the New York Fed designated MF Global a primary dealer, allowing it to trade directly with the bank in the buying and selling of United States government debt.
With worries mounting about MF Global’s solvency, the Fed issued a margin call of its own on Friday, October 28. And the jig was up.
MF Global filed for bankruptcy protection on Monday, October 31. Ever since then, we’ve been unearthing the details surrounding the company’s ultimate demise.
Bottom line: Leverage cuts both ways. Wall Street’s elite always seem to forget about this fundamental principle time and again. Perhaps it’s because they’re always investing with other people’s money instead of their own?
Nevertheless, let MF Global’s bankruptcy be yet another reminder that there are no risk-free trades. And that’s why we should relentlessly favor position-sizing over making outsized bets.
Ahead of the tape,