MF Global and echoes of Repo 105

What caused MF Global’s downfall?

According to Bradley Abelow, MF Global’s Chief Operating Officer, much of the blame may lie with Finra’s unreasonable request for MF Global to add capital to support its off-balance sheet exposure to European sovereign debt and reveal them publicly. These were, as we have discussed, structured as repo-to-maturity trades. They were also maintained off-balance sheet.

In a personal declaration filed in Chapter 11 proceedings (H/T Zerohedge), Abelow writes:

As a global financial services firm, MF Global is materially affected by conditions in the global financial markets and worldwide economic conditions. On September 1, 2011, MF Holdings announced that FINRA informed it that its regulated U.S. operating subsidiary, MFGI, was required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MFGI increased its required net capital to comply with FINRA’s requirement.

Upon this notice, Moody’s got a little skittish. As Abelow notes:

On October 24, 2011, Moody’s Investor Service downgraded its ratings on the Company to one notch above junk status based on its belief that MF Holdings would announce lower than expected earnings.

But that wasn’t good enough for Finra. They wanted the exact details of the trades revealed publicly in MF Global’s October results:

On October 25, 2011, MF Holdings announced its results for its second fiscal quarter ended September 30, 2011. The Company revealed that it posted a $191.6 million net loss in the second quarter, compared with a loss of $94.3 million for the same period last year. The net loss reflected a decrease in revenue primarily due to the contraction of proprietary principal activities.

Dissatisfied with the September announcement by MF Holdings of MFGI’s position in European sovereign debt, FINRA demanded that MF Holdings announce that MFGI held a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity, including Belgium, Italy, Spain, Portugal and Ireland. MF Holdings made such announcement on October 25, 2011. These countries have some of the most troubled economies that use the euro. Concerns over euro-zone sovereign debt have caused global market fluctuations in the past months and, in particular, in the past week. These concerns ultimately led last week to downgrades by various ratings agencies of MF Global’s ratings to “junk” status. This sparked an increase in margin calls against MFGI, threatening overall liquidity.

This brought attention to MF Global’s precarious liquidity exposure to the likes of the CFTC and SEC, pushing MF Global into seeking out alternative arrangements before its liquidity position became too precarious:

Concerned about the events of the past week, some of MFGI’s principal regulators – the CFTC and the SEC – expressed their grave concerns about MFGI’s viability and whether it should continue operations in the ordinary course. While the Company explored a number of strategic alternatives with respect to MFGI, no viable alternative was available in the limited time leading up to the regulators’ deadline. As a result, the Debtors filed these chapter 11 cases so that they could preserve their assets and maximize value for the benefit of all stakeholders.

Specific to everyone’s concerns were, of course, were MF Global’s ‘repo-to-maturity’ sovereign debt trades.

Anyone following MF Global’s regulatory notices would though have been able to spot their disquiet early on.

On September 1, for example, MF Global filed the following:

As previously disclosed, the Company is required to maintain specific minimum levels of regulatory capital in its operating subsidiaries that conduct its futures and securities business, which levels its regulators monitor closely. The Company was recently informed by the Financial Industry Regulatory Authority, or FINRA, that its regulated U.S. operating subsidiary, MF Global Inc., is required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MF Global Inc. has increased its net capital and currently has net capital sufficient to exceed both the required minimum level and FINRA’s early-warning notification level.

The Company does not believe that the increase in net capital will have a material adverse impact on its business, liquidity or strategic plans. In addition, the Company expects that its regulatory capital requirements will continue to decrease as the portfolio of these investments matures, which currently has a weighted average maturity of April 2012 and a final maturity of December 2012.

Regulators’ concern no doubt centred around the fact that such off-balance sovereign positions could pose very real and sudden liquidity issue in terms of margin calls. They were probably also conscious of such things as Lehman’s notorious Repo 105 arrangement.

The fact that the trades depended more on collecting premiums (by holding positions until maturity) whilst being positioned off-balance sheet — rather than outright directional moves in the underlying bonds — was neither here nor there in their eyes.

The key problem was always going to be that the positions — be they off-balance sheet or on –were always going to be subject to cash collateral calls as and when the bonds fell in price. Or, possibly, as counterparties demanded more collateral as they sought to protect themselves from a weakening in MF Global’s positions (potentially possibly and the terms and conditions of the deals).

Whether those margin calls would have come as quickly if those positions hadn’t of been exposed, however, we couldn’t possibly know.

But Bethany Mclean over at Reuters — who has an excellent explanation of the accounting advantage of booking these trades as repo-to-maturity — notes how once the cat was out of the bag and prospective buyers became aware of the degree to which MF Global was throwing cash at a sinking ship, the broker-dealer’s fate became relatively inevitable:

The actual details of the run aren’t clear yet, but according to the CFO’s affidavit, the ratings downgrades “sparked an increase in margin calls,” which drained cash. Plans to sell all or part of the business fell through, reportedly because of the discovery of the missing cash. Another part of the explanation might be that potential buyers found out just how weak the core business was.

Of course, if Corzine made the trades for an accounting play, there’s a deeper question of why he would feel the need to do this. And isn’t that always the question in situations like this?

As to why Corzine felt the need to do the off-balance repo deals, that’s the real question shareholders and investors should now be asking.

Related links:

MF Global and the repo-to-maturity trade
– FT Alphaville
MF Global files for bankruptcy
– FT AlphavilleEuropean bet triggered MF Global’s demise – FT

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