Credit Derivatives and Leverage Sank Jon Corzine's MF Global

Ratings downgrades will trigger increased margin calls. This is all business as (un)usual. What isn't usual is diverting money from segregated customer accounts. It's too late to blame "sloppiness, bookkeeping, or accounting."
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MF Global imploded this week due to proprietary "repo-to-maturity" transactions that are in substance total return swaps, a type of credit derivative. MF Global failed to meet margin calls on credit derivatives linked to risky fixed income debt. Regulators haven't learned much from American International Group's (AIG) and Long Term Capital Management's (LTCM) debacles. Like the "repo-to-maturity" transaction, a total return swap is an off balance sheet transaction treated as a sale, but the total return receiver, MF Global, is long both the price and credit default risk of the reference assets. The total return payer, not MF Global, is technically the legal owner of the reference assets. The attraction of this arrangement is financing and leverage. Naturally, ratings downgrades will trigger increased margin calls. This is all business as (un)usual.

MF Global Admitted "Diverting" Money from Segregated Accounts

What isn't usual is diverting money from segregated customer accounts. It's too late to blame "sloppiness, bookkeeping, or accounting," MF Global admitted it "diverted" money from customers' segregated accounts.

The fact that MF Global was exposed to default risk and liquidity risk because of its "repo-to-maturity" transactions and that the risk was linked to European sovereign debt was disclosed in MF Global's 10K for the year ending March 31, 2011, a required financial statement filed with the SEC. The CFTC and other regulators had the information right under their noses, but it appears they didn't understand that they were looking at a leveraged credit derivative transaction that could lead to margin calls that MF Global would be unable to meet.

Even if all the money can eventually be recovered, it doesn't change the fact the MF Global took impermissible steps.

Liar's Poker

Here's a crazy but true side note. Michael Stockman, the chief risk officer of MF Global (as of January 2011), was in our Liar's Poker training class lampooned by another classmate, Michael Lewis.

More Liar's Poker

Last week when customers asked for excess cash from their accounts, MF Global stalled. According to a commodity fund manager I spoke with, MF Global's first stall tactic was to claim it lost wire transfer instructions. Then instead of sending an overnight check, it sent the money snail mail, including checks for hundreds of thousands of dollars. The checks bounced. After the checks bounced, the amounts were still debited from customer accounts and no one at MF Global could or would reverse the check entries. The manager has had to intervene to get MF Global to correct this.

Rogue Trader and Questionable Risk Management

Gary Gensler, Jon Corzine's former Goldman Sachs colleague and current head of the Commodities Futures Trading Commission (CFTC), had reason to be concerned about MF Global's risk management. In early 2008, a rogue trader racked up $141.5 million in losses in unauthorized trades that exceeded his trading limits. It seems he accomplished this in under seven hours. In August of this year, MF Global and the underwriters of its 2007 initial public stock offering (IPO) paid around $90 million to settle claims by investors that they were misled about MF Global's risk management prior to the rogue trader's actions. Since 2008, MF Global's financial condition has been nothing to brag about.

CFTC's Unprecedented Failure to Move Customers' Assets Before FCM's Bankruptcy

The exchange-traded futures markets have been shaken to the core. The Bankruptcy Code apparently conflicts with the Commodity Exchange Act, so customers of MF Global have less protection than they otherwise might have had. In the past, the exchanges and CFTC "always" moved customer positions before a Futures Commission Merchant (FCM) declared bankruptcy. The CFTC had ample reason to have contingency plans for MF Global based on publicly available information. Yet the Gensler-led CFTC hasn't followed this historical precedent when an FCM led by his former Goldman colleague teetered on the edge of bankruptcy.

Afternote: The "repo-to-maturity" transaction which was treated as a sale is indeed in substance a total return swap, contrary to what damage control spin-doctors may say. The "repo-to-maturity" label is simply a wolf in sheep's clothing. Total return swaps (and the transactions labeled "repo-to-maturity") are also a credit derivative. MF Global itself disclosed the fact it sought sale treatment for this "repo" transaction while retaining the price and default risk. Regulators seemed at a loss as to how to interpret the substance versus the form. For more on credit derivatives and total return swaps, see also either the first or second editions of my book (Wiley 1998, 2001): Credit Derivatives & Synthetic Structures: A Guide to Instruments and Applications.

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