If ever there was an example of an “overnight repo Black Swan” event, MF Global’s “repo-to-maturity” laddered trades seem to be it. Though, in this case, they’re probably better described as the realisation of the “short-term repo Black Swan”.
A.k.a institutions’ growing tendency to risk it in the short-term repo universe, to beat the crappy returns being offered in the “risk-free” market.
So, while most of the media has been commonly referring to MF’s sovereign bond positions as proprietary bets gone wrong, there’s more to it than just that.
If anything this was a financing position (or liquidity trade) — not a bet on the future direction of the bonds themselves.
What’s more, if executed properly the trade should — at least on paper – have posed little or no risk.
The maths was simple enough. You account for the cost of borrowing funds using the bonds in question as collateral (the repo rate) versus the ultimate coupon payments received from the very same bonds.
This is because in dysfunctional markets the repo rate can be out of kilter with the ultimate returns of the bond itself. This is especially the case if there are more counterparties willing to provide short-term liquidity in return for rates that beat the nominal risk-free return. In other words to act as pawnbrokers to the market. Alternatively, if you have a good credit standing in the market you may be able to achieve a more favourable repo rate than others.
If everyone plays their cards right, MF Global receives financing (or liquidity) at a better rate than the market’s – since they are offsetting the repo charges with the ultimate coupon payments — and the counterparty is rewarded in basis points for holding the bond in the interim.
Gross profit is simply total inflow minus total outflow.
As fixed income guru Moorad Choudhry noted in the “Repo Handbook” such a trade should generally be considered low-risk since the financing profit on the bond position is known with certainty until the bond’s maturity.
For financial institutions that operate on an accruals basis rather than market-to-market basis, the trade can guarantee a profit and not suffere any losses in the interim while they hold the bond.
In other words, mark-to-market ought not be a concern. As long as the bond pays out at the price you bought if for (which it will if it is held to maturity), it should not be considered a risky position.
As can be seen from MF Global’s earnings statement, MF was indeed counting on the EFSF guarantee to ensure that this would be the case:
As of September 30, 2011, MF Global maintained a net long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity (repo-to-maturity), including Belgium, Italy, Spain, Portugal and Ireland. The laddered portfolio has an average weighted maturity of October 2012 and an end date maturity of December 2012, well in advance of the expiration of the European Financial Stability Facility in June 2013. (see supplemental table for further details)
“Over the course of the past year, we have seen opportunities in short-dated European sovereign credit markets and built a fully financed, laddered maturity portfolio that we actively manage. We remain confident that we have the resources and expertise to continue to successfully manage these exposures to what we believe will be a positive conclusion in December 2012,” Mr. Corzine concluded.
On top of that — just in case an unexpected default risk came its way — MF Global had actually hedged the $6.3bn position with a $1.3bn short French government bond trade.
So what on earth went wrong?
Italy and Belgium are, after all, still very unlikely to default before the end of 2012. There is no reason, therefore, why the bonds shouldn’t payout.
Which leaves only the possibility of some skittish repo counterparties suddenly getting cold feet and pulling out (or demanding a greater proportion of over-collateralisation with respect to the loan.
If repo contracts were completely reneged upon, this would not only have left MF with a sudden liquidity issue — especially if they couldn’t find a fresh counterparty — but also with a sudden need to mark-to-market the bonds.
Indeed as Reuters reported on Monday:
Last week, counterparties likely pressed MF Global to post more collateral on derivatives trades and may have started reducing the company’s repo financing lines, market sources said.
We’re not sure exactly how easy it is to undo a “repo-to-maturity” trade, but it does leave us wondering who exactly those counterparties might have been.
Update 9.30pm GMT: As Kamekon points out below, in most circumstances — depending on the terms and conditions — repos would be subject to regular margin calls or “loan repayments” which re-establish the original repo ratio. Either way, a fall in the value of the bonds could create a major liquidity drain for MF Global. Though these sorts of liquidity risks should have been accounted for in VaR calculations. Much harder to anticipate would have been a complete disappearance of willing counterparties.
Related links:
The overnight Black Swan - FT Alphaville
MF Global files for bankruptcy – FT Alphaville