As FT Alphaville has noted, Egan-Jones downgraded Jefferies, citing the disclosure in Jefferies’ 10Q that the firm’s “sovereign obligations” amounted to €2.68bn, or 77 per cent of its €3.49bn shareholder equity.
Jefferies, meanwhile, responded that the positions were net short thus not a problem. What’s more that they were not “repo to maturity” or off-balance sheet.
They also pointed out that:
with respect to interest-income expense, Jefferies carries interest-earnings investments that turn over rapidly with its funding. As a result, Jefferies has had significant interest income in the past and should continue to have it in the future.
But that, you see, is the problem (if any).
And it all lies in the following point, outlined in Jefferies 10Q:
In addition, we recognize interest revenue related to our securities borrowed and securities purchased under agreements to resell activities and interest expense related to our securities loaned and securities sold under agreements to repurchase activities on an accrual basis.
While the issue with MF Global’s sovereign positions was that they were off-balance sheet and repoed-to-maturity, Jefferies, it turns out, is suffering from exactly the opposite syndrome.
To understand what we’re on about consider first that repos are in many ways the equivalent of institutional mortgages.
In MF Global’s case, the institution had taken out a prudent(-esque) mortgage on a fixed term basis because it knew the fixed term rates offered in the market at the time were super attractive. To keep the housing analogy going, it knew it could not only afford to make the monthly repayments but receive a rent which more than covered the monthly repayments (thus earning a profit).
And better still, because it was holding the ‘house’ to maturity, it could ensure that however many years down the line it would receive exactly the same amount it bought it for. There was thus no resale risk like there would be for a normal house-buyer. In many respects it seemed like a dead certain trade. As a result, from an accounting perspective, it could book the arrangement as a sale and sit back and collect the rent.
The problem, of course, came about because MF Global was ultimately still exposed to that final pre-arranged repurchase amount going through. If the bond defaulted (or the house, erm, burned down) it was still their liability to make the final payment. That meant the lender was obliged to demand an ever growing deposit over the duration of the loan, to cover its interests in the event that there was no asset at the end of the day to liquidate.
It’s for this reason the FASB and Finra felt MF Global could no longer account for this as a dead certain trade, and demanded — via a new rule introduced in April – that it announce the exposure while setting aside more capital for the trade.
In Jefferies’ case, however, the situation is quite the opposite. Unlike MF Global they have decided to exploit the wide spread which exists between borrowing and lending in the market. If they can receive more interest from lending than borrowing, it’s a winning trade. The critical distinction being that they’re operating in the equivalent of the variable market (conventional repo) on the expectation that certain rates might rise. By taking a bigger short position than a long one, they can receive more interest rate revenue than they are paying out — while being fairly hedged on the position. This is why they have an overall net short exposure of €38m.
Of course, in conventional repo the problem is that there are no fixed rates. Worse still, there’s no guarantee that you can keep the matched trade going since there is no obligation on the part of your counterparties to stick by you. They can and are entitled to pull out at any time.
From a borrower’s point of view that means the mortgage lender can withdraw their loan at any point. But much worse, from the lender’s point of view (i.e. if you are short), the borrower can pay off their ‘mortgage’ without penalty at any point too. End of trade.
So while Jefferies currently has a working net short position, there’s nothing to say counterpatries can’t and won’t get skittish. If they were to pull out, and if Jefferies couldn’t find alternatives quickly that would leave them either running a capital intensive, liquidity crunching net long position of €2.684bn or needing to drop rates on the repos arrangements in order to attract any counteparties at all. If these rates dropped too far, that could see the interest they pay out (on the long side of the trade) surpass the interest they take in.
Meanwhile, as far as accounting goes, since Jefferies has been booking interest on an accrual basis — that would translate to immediate and potentially unsustainable net interest losses for the company.
What’s the scope of the danger? Well, according to Jefferies, its short-term trading positions are turning over approximately three to four times per weeks. Explained another way, that means counteparties are currently rearranging terms and conditions on such repos up to three to four times a week. Each time, potentially, to their favour.
The risk at Jefferies therefore is not so much the trade as it stands, but what happens if a) these borrowers pull out altogether at very short notice or b) force Jefferies into terms that force it into booking net interest losses which it has to book on an accrual basis.
Update: There’s also the issue of general exposure to counterparties who may have trouble delivering additional margin to you.
Generally speaking, however, if the trade was equally weighted you could consider it well constructed, designed specifically for a credit intermediary to earn a spread on interest income. Though according to commenter Capra.Iberica it could be unequally weighted, i.e. short Spain and long Italy — making it very much an imperfect hedge that could soon hit the interest income.
And as with all trades, it’s highly dependent on the good standing of your counterparties. What’s more, the ones more likely to cut and run are facilitating the shorts in Jefferies’ position rather than its longs.
Related links:
Jefferies statement – Businesswire
The continuing mystery of US banks’ European exposure – FT Alphaville
MF Global and repo to maturity – FT Alphaville