The "Low-Risk" Trade That Brought Down MF Globalhttp://www.fool.com/investing/general/2011/12/16/the-low-risk-trade-that-brought-down-mf-global.aspx Alex Dumortier
December 16, 2011
"There is no hard line between arbitrage and speculation; it is a continuum."
On Oct. 25, MF Global's (OTC: MFGLQ) CFO told analysts and investors that he was "proud to say our capital structure has never been stronger." Six days later, the broker filed for bankruptcy. Here's the extraordinary story of the trade that got away from CEO Jon Corzine and ultimately toppled his firm over the course of two weeks.
A bad day at the office
Eight days prior, The Wall Street Journal reported that one of the firm's regulators, the Financial Industry Regulatory Authority, insisted in August on an increase in the amount of capital at MF Global's U.S. broker-dealer subsidiary specifically in relation to that very trade. As Corzine later recounted in Congress, "Some of MF Global's counterparties decided to reduce their exposure to the company, requiring some adjustment in our financing." Corzine didn't know it yet, but the article had sealed the firm's fate; the attention it received set in motion a series of events that would end two weeks later in a bankruptcy filing.
FINRA was also demanding that MF Global include a specific disclosure concerning the European sovereign debt trade, known as "repo-to-maturity," in the earnings press release that would go out just before the start of the call. The disclosure figured prominently in the release and included a table breaking down the $6.3 billion exposure between five countries: Italy, Spain, Belgium, Portugal, and Ireland.
Although MF Global's public filings contained detailed information on the positions and their risk, no one had really paid it much attention until The Wall Street Journal published their article. With increasing urgency, investors were asking themselves what exactly a repo-to-maturity was, and how much could MF Global lose on them?
Brought in to turn MF Global around, Corzine was now under immense pressure, and he knew he could expect some probing questions on the call. If he could just ride out the trade until its last maturity in December 2012! At maturity, the bonds MF Global bought and simultaneously used as collateral would be redeemed at par and any unrealized losses due to fluctuating bond prices would revert to zero. Corzine was not unaccustomed to pushing high-stakes situations to the limit; he had pulled through two similar ones at Goldman Sachs (NYSE: GS ) .
Back to the floor
In 1994, Goldman had a horrendous year. The firm's proprietary traders -- for which Corzine was responsible as co-head of fixed income -- had made a huge bet on interest rates and they were mowed down when the Fed unexpectedly raised rates in a series of hikes. Corzine and the other co-head, Mark Winkelman, had sanctioned the trade, which racked up hundreds of millions of dollars in losses over a period stretching several months. Many of Goldman's partners became genuinely concerned about the longevity of their capital account, to a point where 40 partners left at the end of 1994 -- much more than normal attrition.
In one respect, however, Corzine's present situation was very different from those he had experienced at Goldman Sachs. Back in 1994, Corzine was only required to justify his positions to a senior partner (Goldman was still a private partnership then). Facing the scrutiny of the public markets -- including analysts, institutional shareholders, and regulators -- was a different ballgame altogether, with a very different set of rules. He certainly wasn't used to people telling him what to divulge and when.
The trade: No different than a rental property
Repo-to-maturity refers to the fact that the term of the loan coincides with the maturity of the bond, at which time MF Global receives the face value of the bond, which it uses to repay its loan. In a textbook version of this trade, with no risk of default on the bond and a secure loan, the profits you earn are riskless. Of course, the textbook version assumes you'll still be alive to complete the transaction at maturity. In the real world, for a financial firm to stay alive means paying careful attention to all manner of things that may have nothing whatsoever to do with the trade itself.
Will they or won't they?
During the earnings call, Corzine told analysts that "the structure of the [European sovereign debt repo-to-maturity] essentially eliminates market risk," reasoning that any unrealized loss on the bonds would vanish at maturity once the bonds were redeemed at their par value.
If we return to our housing analogy, let's imagine you've arranged at the outset of your housing investment to sell the property at a pre-arranged price. The sale will occur simultaneously with the end of the tenancy and that of your loan.
In the meantime, you can have the house reappraised as often as you like in order to establish its value based on current transaction values in your neighborhood (for a trading book, that process is known as "marking-to-market"). Remember, however, that you have already contracted to sell the house at a set price at the end of your ownership period. Provided your buyer is reliable, you needn't concern yourself with any of the fluctuations in the value of the house between the time of its purchase and the sale.
Corzine's reassurance didn't satisfy the analysts who were listening closely; they wanted hard numbers to make their own assessment. "Henri, are you able to break out the 0.7 million [loss in the principal trading activity] between market-making losses and maybe mark-to-market writedowns related to the European sovereign portfolio?" asked Howard Chen of Credit Suisse, addressing the question to MF Global's CFO, Henri Steenkamp.
The analysts already had the breakdown of the trades by country and by maturity, and Corzine had spent quite a bit of time describing the trades and their risks during his prepared remarks. "Why are we discussing this?" he must have thought to himself, "These positions haven't moved and even if they had, the losses would vanish at maturity."
The analysts weren't letting up. Roger Freeman of Barclays Capital followed Howard Chen. Among other points, Roger wanted to know what kind of haircut banks were currently requiring on the same bonds (the haircut is the discount between the face value of the bonds and the amount they are willing to lend). Corzine and Steenkamp found themselves quoting prices for specific European sovereign issues. It's completely unheard of for the executive management of a broker-dealer to know the prices of individual bonds in the firm's inventory.
Instead of quelling concerns, each new question was drawing more attention to the trades and raising new ones. This was just what Corzine wanted to avoid: He understood the risks attached to this European sovereign debt exposure and he was managing the positions personally -- that should have been the end of it as far as he was concerned. Corzine felt the trades had become a distraction, that they had "clouded [investors'] perceptions with respect to our other progress."
You'll have to stick around
Years earlier, Corzine displayed the same rigid, compartmentalized thinking under eerily similar circumstances. While he was head of the fixed income division at Goldman Sachs, he was eager to put a large position in farm credit bonds and sought approval from the two co-senior partners of the firm, Robert Rubin and Stephen Friedman, explaining that the expected return was attractive and the risk of default was virtually nil as the bonds had the implicit backing of the U.S. government. The issuer was Farmer Mac, a new government agency that has a similar function to that of Fannie Mae and Freddie Mac for agricultural and rural properties.
Impossible or just highly unlikely?
No outright bond default was required to destroy MF Global. Corzine was considering the risks of the trade -- such as default risk -- as if each one were self-contained. In his prepared statement to the House Committee on Agriculture on Dec. 8 -- over a month after the bankruptcy -- he had the gall to remark that "as of today, none of the foreign debt securities that MF Global used in the RTM trades has defaulted or been restructured" -- as if that somehow mattered! He couldn't imagine that less-prominent risks could band together and produce the same result, with regulatory risk, business risk, and earnings risk combining to force a rating downgrade, thereby creating liquidity issues. Worse still, MF Global was holding a dangerous combustible perfect for igniting that process: leverage.
Leverage has other effects beyond magnifying a firm's losses; it also contributes to raising the risk of a credit rating downgrade. Ratings agency Moody's had told MF Global that it needed to manage its leverage ratio down into the 20-times range in order for it to keep its Baa2 rating, which was