MF Global lost ‘effective control’ of its sovereign bond assets. This gifted the broker some rather favourable accounting treatment. The broker’s clients, meanwhile, wanted to keep effective control of their own assets, and not just in the accounting sense, but in a very real sense.
As creditors and clients pick over the corpse of MF Global, reaching into its pockets for anything that can compensate them, we’re learning a lot about accounting for repos, and about what does and doesn’t work when it comes to protecting client assets.
How to lose effective control with really trying
To quickly recap, whether a repurchase transaction is recognised as a collateralised borrowing or an outright sale of assets hinges in large part on whether the seller of assets / borrower of funds has lost or retains ‘effective control’ of the assets. At least for the purposes of accounting in the US.
Lehman’s Repo 105 transactions took the rather interesting tack of ‘selling’ them for a price that was a bit on the low side. This meant that they had lost effective control because they would be unable to buy back the assets using the cash they’d gotten from the lender (because they were paid too little).
If you are wondering how it could ever, ever make sense to view the world in this way, think about what would have happened if Lehman’s counterparty had filed for bankruptcy (don’t laugh). In that case, Lehman would be sitting on the cash it received and could use it to purchase similar or identical assets in the market. But as stated, Lehman wouldn’t be able to afford them. Hence Lehman must have sold the assets (at a loss). It did so anyway because the cash was sorely needed.
A funny bit of history is that this same accounting treatment was a negative for AIG’s securities lending business. AIG was a natural holder of securities, as an insurance business. It would lend its securities for cash and then use the cash to invest in RMBS that often had a longer maturity than the loan of securities. That didn’t end well.
But even before that, the business model of securities lending came under pressure, with AIG forced to accept less and less cash in exchange for its securities. So little, in fact, that it had to start recognising them as a sale, i.e. AIG lost effective control and had to book a loss accordingly. Though this wouldn’t be nearly as big as the losses it would incur on the RMBS.
Hence AIG is a curious case of an organisation that wasn’t even trying to get sale recognition — which moves the transactions off balance sheet — and yet its hand was forced.
MF Global lost effective control not because of getting too little cash (or maybe that too), but primarily because the funding for its bond holdings matured at exactly the same time as the bonds themselves did. Therefore there were no further opportunities for control of the assets.
What do you think about the principle of ‘effective control’ now?
This year, the Financial Accounting Standards Board has taken an axe to exactly this principle, but some argue that it doesn’t go nearly far enough. FT Alphaville agrees with the Grumpy Old Accountants who argue that one should look at the economic substance of the transaction. This could be nicknamed the No Bull$hit Approach whereby you have to acknowledge if you are still exposed to the changes in value of the asset, and/or indeed you still retain rights to coupon payments.
MF Global retained, however, the risk that the debt securities might default or be restructured. If the debt securities defaulted or were restructured, then MF Global would not be paid in full at their maturity, even though MF Global would still have the obligation to buy back the debt securities from the Counterparty in full (at par).
Sounds like a “yes”.
How to lose effective control without really trying
About those client assets, and another legacy of Lehman. Why, oh why, did we not learn enough about how to properly segregate assets? A bit of jargon: rehypothecation.
Rehypothecation is where a bank/broker takes client assets and repos them out. While that sounds iffy, it was (and in many places still is) normal practice. The upside for the client is cheaper funding from the broker because the client isn’t proving to be such a burden on the balance sheet. Sure, a client may request a fully segregated account and forbid the dealer from rehypothecating, but then expect higher costs. (Unsurprisingly, clients are proving more willing to bear the higher costs these days.)
But the terrifying thing about MF Global is that not only have a lot of the ‘missing’ client funds seemingly been lost through seemingly legit rehypothecation that clients may not have been aware of (and yes, they probably should have known better), but there’s also some cross-border arbitrage coming to light.
As Reuters points out (and you must go read the full article for more on the scale of rehypothecation):
Under the U.S. Federal Reserve Board’s Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client’s liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.
But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).
The next terrifying thing is that even clearing, that great regulatory panacea, didn’t help.
Risk points out that non-US clients of MF Global have been largely unable to move (“port” in the jargon) their positions to another Futures Clearing Merchant (FCM). This is because the FCMs that are still standing want collateral and the clients can’t access the collateral that they posted with MF Global. And without that they are having (or have already had) their positions liquidated. Risk explains how this came to be:
European clients, for example, are not allowed to be a client of a US futures commission merchant (FCM) and are required to access the FCM indirectly. The client would open an account with a foreign broker, which in turn has an omnibus account with its affiliate FCM. In the case of MF Global, UK clients held accounts at MF Global UK Ltd (MFGUK), which opened an omnibus account with MF Global Inc (MFGI).
In the event of the FCM’s insolvency, the foreign broker enjoys the same protections with respect to margin segregation and portability of positions as any other direct client of such FCM, but the omnibus structure contains pooled positions for all the broker’s non-US clients and does not necessarily ensure those clients can port their positions or have their margin segregated from other clients within the structure.
Why this is so concerning:
The lack of protection in the omnibus structure has caused some dealers to re-examine it, given they expect it to be used in the clearing of OTC products. “We’re holding fire on this and are not implementing the structure as yet for OTC swaps. We’re trying to figure out what the cross-regulatory streams mean and which rule should govern, and what that means for client money protections. If porting and the return of customer assets is a problem, then clients are going to think twice about using this structure. That said, the way regulations are currently written means clients might have to make use of this structure. So if a client is compelled to use it, we need to be absolutely sure what needs to happen in the event of a default,” says one head of OTC clearing at a US bank.
FT Alphaville just got an idea for the next wave of crisis porn! Clearing: How ill-thought out, uncoordinated regulation brought the system to its knees. Ok, ok, it’s not just clearing, and we’ve already been there concerning the unintended consequences of regulation…
(Publishers welcome to inquire.)
MF Global: non-US clients caught in cross-border collateral trap - Risk
MF Global and the great Wall St re-hypothecation scandal – Reuters
Regulators diverge over MF Global collapse – FT
MF Global accessed client funds for weeks – FT
MF Global Collapse Felt in Farm Country – WSJ