"There is no hard line between arbitrage and speculation; it is a continuum."
-- Stephen Ross, professor of finance at MIT
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
When he got up on the morning of Oct. 25, Jon Corzine knew he had a tough day ahead of him. Beginning at 7:30 a.m. Eastern time he would be presiding over a conference call to discuss MF Global's results for the second fiscal quarter ending Sept. 30. The numbers weren't good, and on the previous day credit ratings agency Moody's had downgraded the broker to one notch above junk status and warned that the rating was under review for a possible additional downgrade. Part of Moody's rationale pertained to a huge trade involving the government bonds of five troubled European nations -- a trade Corzine himself had "strongly advocated" and that he was now managing personally.
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.
With the table indicating Italy as the largest country exposure -- half the total amount -- the timing of the release was awful. The European sovereign debt crisis had been the primary focus of markets worldwide through much of the summer. In the early hours of Oct. 25, while New York was asleep, six hours ahead in Rome talks between Silvio Berlusconi and his coalition government partners failed to produce an agreement. The Italian government was veering toward collapse.
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
Back to the floor
In 1986, Corzine had been called back to duty on a trading desk to take on the responsibility for managing a massive bet in the U.S. Treasury bond market which threatened to saddle Goldman Sachs with $150 million in losses (this was back when $150 million was real money and Goldman was a much smaller firm). After five agonizing and intense months -- during which Corzine reported to the management committee every other day -- the trade began to move his way and he ended up turning a $10 million profit.
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.
Despite this, even Stephen Friedman, the senior partner of the firm, couldn't get Corzine to reduce the size of the positions. Corzine was confident and refused to countenance any doubt. "The worse it appears, the better the reality," he said. "The probability is strong that if we hang on, and even increase our position, this can be a real winner."
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
While media accounts often suggest MF Global's trade is "complex" or "sophisticated," the basic idea behind a repo-to-maturity transaction is very simple. It's comparable to buying a rental property in order to pocket the excess of the rental income over the cost of the mortgage. With a repo-to-maturity, MF Global borrowed money in order to buy European bonds and put the bonds up as collateral on the loan (just as a house is collateral on its mortgage). The point of the trade was to collect the difference between the yield on the bonds and the borrowing rate.
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?
The trade itself was far from risk-free. Corzine was heavily focused on the possibility that one or several peripheral European countries would default on their bonds and he was satisfied that this was well mitigated by the European Financial Stability Fund, or EFSF. Never mind that the EFSF had offered no specific guarantees backing Italian or Belgian debt, or that many investors were questioning the size of the EFSF, particularly in regard to Italy, which has the world's third-largest government bond market.
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.
"There is zero [loss] related to the European sovereign portfolio," Corzine interjected. These were his trades and no one was following them closer than he was.
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
In a very narrow sense, Corzine was right: A default on those bonds remains unlikely and market risk would have had no impact if MF Global had been there to collect at maturity. The trade would almost certainly have been profitable; unfortunately, the size of the trade itself created a material risk that the firm would never see the maturity date. In the context of a wider set of risks -- earnings volatility, a credit downgrade, and liquidity risk, to name but three -- he was dangerously wrong.
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?
Rubin and Friedman challenged Corzine, asking him what would happen in a crisis scenario in which the government declined to stand behind Farmer Mac. In his autobiography, In an Uncertain World, Rubin recounts:
"That's silly." Corzine replied. It was inconceivable to him that the government would not honor its moral obligation, and in a sense he was right. But Steve and I didn't want Goldman Sachs to cease to exist after 130 years because something that we agreed was virtually inconceivable actually happened ... the decision to limit the risk was right.
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.
MF Global was leveraged to a level that Corzine himself had recognized as imprudent. In October 2010, roughly seven months into the job, he told Financial Times in a video interview, "We have to be disciplined; we can't go running 30:1 leverage ratios on our balance sheet." In fact, that ratio was rarely below 30:1 during Corzine's tenure. At 30:1, a 3.5% impairment in the value of a financial firm's assets is all it takes to wipe out shareholders' equity.
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 on negative watch and had been throughout Corzine's tenure.
When you're at risk of a downgrade, a Baa2 rating isn't a great place to start from, either. It's "medium grade, may possess some speculative characteristics," and "Ba" is below-investment grade, i.e., junk status. If you're a soap manufacturer, a rating downgrade doesn't harm your activity per se; if your business is money, on the other hand, peoples' perception of your ability to repay your obligations is like the oxygen level of your franchise. The lower it drops, the more difficult it becomes to operate; below a certain level, it's terminal. Under those circumstances, it behooved MF Global to manage its relationship with the ratings agencies with exceptional care and consideration -- they were certainly more important than any client. As the former senior partner of Goldman Sachs, it must have been difficult to swallow the fact that MF Global did business at the pleasure of Moody's and Standard & Poor's.
The shortcut to the board
MF Global had a solid-looking risk management organization -- on paper. Its hierarchy of different risk committees overseeing every flavor of risk (market, credit, liquidity, operational, etc.) resembles the one at Goldman Sachs, which is the gold standard for risk management on Wall Street. However, Corzine -- who "strongly endorsed" the trade -- was outside that hierarchy since he reported to the board exclusively. Although he discussed the trade with the board and with MF Global employees, as CEO, there was little chance he would receive open or adequate feedback from people whose reporting lines all ended on his doorstep. Corzine was, in effect, negotiating position limits directly with the board.
In 2010, Michael Roseman, at the time the firm's chief risk officer, actually presented Jon Corzine with several sobering potential scenarios in the event of a credit rating downgrade. Corzine rebuffed him, dismissing the most pessimistic scenarios as unrealistic -- perhaps even impossible. In January 2011, Roseman was informed that the chief risk officer role was being handed to someone else; he left MF Global in March after a handover period.
On Oct. 25, trading volume in MF Global shares surged more than 10 times from the previous day's volume. By 4 p.m., the stock had lost 48% of its value. Two days later, Moody's and Fitch Ratings administered the death blow by downgrading MF Global to junk status. The company's fate was no longer in Corzine's hands, as the downgrade triggered margins calls and requests for customer redemptions, sparking a classic run on the broker. Five days later, on Oct. 31, MF Global filed for bankruptcy in the U.S. Bankruptcy Court for the Southern District of New York. Jon Corzine had been CEO for 587 days.
In the next chapter, we assess blame for the oversight failure at MF Global. Click here to read all about it.