The demise of MF Global was triggered by a risky bet that sought to exploit the difference between the cost of its borrowings and the interest payments on European sovereign debt.
The bank’s fall has been popularly linked to the broker-dealer’s foray into proprietary trading and straightforward directional bets on Eurozone sovereign bonds. But its bets were based on a more complex arbitrage strategy that eventually left it carrying losses on a net $6.3bn exposure to Italian, Belgian, Spanish, Portuguese and Irish debt.
In its October 25 earnings statement, MF Global used one of the more arcane and inelegant terms in the credit market lexicon to describe these bets – “repo-to-maturity” trades.
These trades sought to take advantage of the European financial stability facility’s guarantee, expiring in June 2013. This guarantee meant that MF Global could be sure of the coupon payments on bonds it bought.
So the bank bought a swath of European bonds offering high yields and maturities ending no later than December 12 with so-called “repo” financing – a method of funding common in financial markets where one party agrees to sell and repurchase an asset, such as bonds, at a pre-determined price.
Like other repo deals, MF Global used the bonds themselves as collateral. The twist from usual repo deals, which can be unwound at any point, was that the bets had a fixed term – the maturity of the bonds.
The positive side of this was that MF Global was seeking to lock in returns, the gap between the funding cost and the coupon rates.
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
John Corzine, from MF Global’s October 25 statement
However, the trade’s greatest folly was that as the market prices of the bonds fell sharply, it would have to pay higher amounts of collateral, soaking up its liquidity. Jon Corzine, the company’s chief executive, noted in the October 25 statement that the company felt confident it would have the resources and expertise to manage these exposures until their maturity.
However, as concerns about MF Global itself spread, it also came under greater demands for collateral from counterparties on trades. These concerns escalated after Moody’s Investors Service warned on October 27 that MF’s positions may have exposed the firm to a heightened risk of loss of client and counterparty confidence
Moorad Choudhry, head of business treasury at Royal Bank of Scotland, explained in his book The Repo Handbook that one of the main reasons for entering into repo-to-maturity is to fix a funding rate against the return on the asset. If you can ensure a good rate, then on paper the trade can work out to earn easy basis points.
“In theory, this guarantees a positive return, provided the return from the asset exceeds the funding cost for the term of the trade,” he wrote.
But some market experts suggested the trade made little sense and was as risky as a directional bet, if not more.
“It’s no good having a straight position if you can’t wear the unrealised volatility on a day-to-day basis,” the same market expert said.
Lena Komileva, chief economist and managing director at G7 Market Economics, said: “Since the heydays of securitisation, banks have continuously confused operational risk for market risk – leveraging off high-yielding but illiquid assets has a damaging effect on both a bank’s capital and on market liquidity.”