Last December, I excoriated the credit ratings agencies for failing to understand the nature of the risks that ultimately led to the failure of MF Global (OTC: MFGLQ). However, after further research, I am beginning to wonder if MF Global misled Moody's
"MF Global made clear to Moody's for the first time…"
At the beginning of February, Moody's Chief Credit Officer Richard Cantor told the House Committee on Financial Services in prepared testimony [emphasis mine]:
During the meeting [on Friday Oct. 21, 2011 -- 10 days prior to the firm's bankruptcy filing], MF Global made clear to Moody’s for the first time that MF Global’s repurchase-to-maturity transactions were not client-driven transactions, but instead were purely proprietary trading positions. Moody’s had understood that MF Global was expanding its principal trading activity for the primary purpose of facilitating customer transactions, as opposed to generating trading profits. That understanding was developed over time through numerous meetings and discussions with MF Global management, and a review of information provided by the company and public filings.
Let's leave aside for now the content of private meetings and discussions with MF Global management and Moody's review of any non-public information the company may have provided to the credit agency. In the absence of any other information, a review of public filings and other publicly available information published months before the October meeting was enough to show that the European sovereign repo-to-maturity transactions (hereafter ESRTMTs) were purely proprietary, not client-related.
"…we saw principal trading opportunities in European sovereigns this quarter."
For example, on May 19, 2011, MF Global CFO Henri Steenkamp made the following prepared remarks to investors on the company's FQ4 2011 earnings call [emphasis mine]:
As Jon mentioned, we saw principal trading opportunities in European sovereigns this quarter. By entering into resell and repurchase transactions to maturity, as we do in US government securities, we are able to capture arbitrage opportunities in these markets. We believe the market risk to these trades is minimal, as these are held to maturity. While we retain exposure to the underlying credit throughout the maturity period, the duration of these trades is short-term in nature. Additionally, we continue to reshape the balance sheet to capture higher margin opportunities, and as such, our matched repo and stock loan book continues to move lower… As the incremental returns in this area continue to remain relatively low, we have reduced our lower yielding match book.
How can we deduce that the ESRTMTs Steenkamp refers to are proprietary? First, Steenkamp's language suggests that the trades were initiated by MF Global, not by a client. Specifically, he says MF Global's traders "saw principal trading opportunities" that enable the firm to "capture arbitrage opportunities [in the European sovereign RTM market.]" That suggests the firm acted pro-actively and independently, putting on these trades to capture an arbitrage it had identified rather than to facilitate client trades.
On its own, that would not be enough to establish with any certainty that these trades were proprietary. However, Steenkamp confirms that is the case when he contrasts the activity in ESRTMTs with that in the lower margin "matched repo book," which the firm reduced during the quarter. Matched repo trading is an industry term that refers specifically to market-making -- taking the other side of client trades.
No quibbling about it: MF Global owned the risk
Note that regardless of whether the ESRTMTs were proprietary trades or part of a market-making book, Steenkamp was upfront and explicit in warning investors (and credit rating agencies) that MF Global owned the credit risk exposure.
On the day following the earnings call, MF Global filed its 10-K for the fiscal year ended March 31, 2011, which contained multiple indications that the firm's sizable exposure to peripheral eurozone sovereigns was proprietary. For example, on page 17, MF Global warned investors about the funding risk linked to the ESRTMTs -- which it specifically designated as proprietary -- including the risk relating to a credit rating downgrade [emphasis mine]:
Events that would affect the funding or financing of our proprietary transactions include systemic events in the market such as, but not limited to; deterioration of broader market conditions or a global contraction of liquidity as occurred starting in 2007, as well as events unique to MF Global such as, but not limited to, a rating down-grade. In either case both funding and liquidity restrictions can result in significant losses for the firm. For example, as of March 31, 2011, we maintained an inventory of European sovereign indebtedness, which we financed using repo-to-maturity transactions; to the extent that the value of these investments decreased due to a ratings change with respect to the issuer’s long term indebtedness, we would likely be required to furnish additional margin to our counterparty.
As we've established above, public statements from the company's senior executives and disclosures included in the firm's public filings refuted the notion that its ESRTMTs were simply client-driven transactions months ahead of MF Global's failure (the examples I have provided above are not unique.)
Moody's and S&P both harbored the same misapprehension
I could certainly understand if Moody's Vice President and analyst Al Bush, who was responsible for covering MF Global, had missed these elements -- after all, it is easier to identify them with hindsight. However, it struck me that Standard & Poor's was under exactly the same misapprehension regarding these trades as Moody's. Indeed in his report dated Oct. 26 -- just five days prior to MF Global's bankruptcy -- Standard & Poor's credit analyst Vikas Jhaveri wrote [emphasis mine]:
For example, the company has disclosed its exposure to certain European sovereign debt, which amounts to approximately $6.3 billion and represents 5.2x the company's total equity. We consider this exposure to be very high, compared to the company's loss absorbing capital base. MF Global entered these short-term repurchase agreements as a means to facilitate client trades... While the rating is on CreditWatch negative, we will continue to gather and assess additional details about MF Global's strategic plans, balance sheet management, and plans for its future proprietary trading activity. (Standard & Poor's, Research Update: MF Global Holdings Ltd. Rating Placed On CreditWatch Negative, Oct. 26, 2011)
Two observations that don't add up
To summarize these findings:
- MF Global's public disclosures, whether in company filings or management's comments, were sufficient to determine that its ESRTMTs were, in fact, proprietary.
- Despite this, the two most influential credit ratings agencies -- those with the highest degree of access to MF Global's management – believed that these trades were client-driven.
It's not easy to reconcile those two observations. To me, the most obvious explanatory hypothesis is that MF Global misled, either actively or by omission, both agencies regarding the nature of these trades. On that basis, I submitted the following questions to Moody's Mr. Cantor by email [I had already contacted Standard & Poor's regarding this and other topics for my December article without any success]:
- Prior to the meeting of Oct. 21, 2011, did Moody's ever explicitly ask MF Global executives, employees or Board members whether the ESRTMTs were proprietary in nature?
- If the answer to question (1.) is 'no', why not?
- If the answer to question (1.) is 'yes' or if the subject of the nature of the ESRTMTs ever arose during a meeting or discussion between MF Global and Moody's, did MF Global executives or employees ever allege or imply that the ESRTMTs were client-driven rather than proprietary?
- If the answer to question (3.) is 'yes', did MF Global ever provide any evidence to support that notion?
- What prompted MF Global to inform Moody's that the ESRTMTs were proprietary during the Oct. 21 meeting? Did MF Global volunteer this information or did they provide it in response to a question from Moody's?
- Which of the MF Global representatives at the Oct. 21 meeting informed Moody's that the ESRTMTs were proprietary? In your statement before Congress, you indicated that "Jon Corzine and members of his senior management team" were present at the meeting. I must assume that then-CFO Henri Steenkamp was part of that group, since managing MF Global's relationship with the rating agencies was one of his responsibilities.
- How did Moody's respond on discovering that the ESRTMTs were, in fact, proprietary?
I was contacted via email by Michael Adler, a Moody's vice president in corporate communications, who indicated that he wanted to follow up with me by phone. When I responded that the questions I had submitted to Mr. Cantor were very specific and that I would prefer a written response, I received one:
"Richard Cantor passed on to me your inquiry on regarding his recent testimony. Moody’s and Mr. Cantor have no further comment beyond that testimony."