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.
Corzine Resigns From MF Global After Bankruptcy
MF Global's Repo Transactions Drew Regulator Attention in March
MF board seen beholden to Corzine as risk grew
MF Global CEO Jon Corzine resigns under fire
MF Global Auditor PricewaterhouseCoopers Subpoenaed for Client Fund Data
Morgan Keegan Bidders Said to Cut Offers in Wake of MF Global
MF Global Liquidators See Asia-Pacific Units Sales
Chinese May Look at MF Global Metals Business
"total return swap"
Added to collateralized debt obligations (CDO's), credit default swaps, tranches, etc........
all that sh--t makes my head hurt.
Who can understand never mind keep up with all that stuff?
No wonder we (ordinary people never mind governments) were ripped off.
If you can NOT understand it, you should NOT be messing with it.
CME Issues Clarification On Margins: To Usher More Risk, Less Liquidity In MF Aftermath
Judging by the broad response, our initial reaction is what a prudent, logical human being would assume: after all, it is precisely the undercollateralization of customer accounts, and general underfunding at MF Global that is what brought that particular company down. Well, we wrong wrong. The CME, it appears has taken a page right out of the European playbook, and less than a week after an exchange-cum-Primary Dealer collapsed due to excessive risk taking, the CME has followed up its vague press release from yesterday by inviting even more risk in lowering the initial margin. Why is this a cause for even greater concern? As the CME itself says, "Initial margins are set to provide an additional buffer against future losses in the account" - so going forward that buffer has been reduced by about 30%. But what is the reasoning provided by CME: "The intent and effect of these changes is to decrease the size of any margin calls resulting from the bulk transfer of MF Global customers to new clearing members, not to increase them."
http://www.zerohedge.com/news/cme-goes-margin-defcon-1-makes-maintenance-margin-equal-initial-everything
CME Goes To Collateral DefCon 1: Makes Maintenance Margin Equal To Initial For... Everything!?
It is critical, because not only is this announcement a direct consequence of what happened with MF Global several days ago, but because also it confirms one of our biggest concerns: systemic liquidity is non-existanet.
We confirmed interbank liquidity in Europe was at an all time low earlier today, and can only assume the same is true for US banks. But what is very disturbing is that this is just as true at the exchange level, where it appears the aftermath of the MF collapse is just now being felt.
What exactly was the announcement. Unless we are completely reading it incorrectly, it is nothing short of a margin call for tens if not hundreds of billions worth of product. Because as of close of business on November 4, today, the CME just made the maintenance margin, traditionally about 26% lower than the initial margin for specs, equal. For everything.
Which means that by close of business Monday, millions of options and futures holders will be forced to deposit billions in additional capital to the CME just so they are not found to be margin deficient, and thus receive a margin call.
They don't understand their risk, because in order to elucidate the amount of risk they are taking clearly at this level of complex leverage would require near perfect psychic foresight, which none of them will ever have. Further, why should they care about risk at all, when they have no skin in the game? They're not partners with equity, they play with shareholders money and extract payment. If they made a law that they all had to have 100% of their own money in the funds, and had to be the last man out, then risk taking would moderate.
"Something for nothing, it never loses its charm."
-Michael Lewis,
Liars Poker
The Collapse of Our Corrupt, Predatory, Pathological Financial System Is Necessary and Positive
We are being throttled by the Big Lie: we're told that if the predatory financial system implodes, we'll all be ruined. The opposite is true: the only way to save our economy is to let the corrupt, pathological and flawed financial system implode.
I was recently challenged by a contributor to write something positive, and so I decided to write about the single most positive outcome of the current financial crisis in Europe: the complete collapse of the corrupt, predatory, pathological global banking sector and its dealers, the central banks. Exploring why this is so reveals the insurmountable internal conflicts in our current financial system, and also illuminates the systemic political propaganda which is deployed daily to prop up a parasitic, corrupting, pathologically destructive financial system.
Our first stop is modern finance itself. Modern financial "products" and "instruments" are often highly complex and abstract, but the entire edifice can be distilled down to this: the system is based on the assumption that all risk can be hedged, and the difference between the initial position's yield/gain (i..e. placement of capital at risk for a gain) and the cost of hedging the risk of the wager to zero can be skimmed from the system risk-free.
"“Make no mistake: fraud is a business model,” said Janet Tavakoli"
http://www.huffingtonpost.com/janet-tavakoli/fraud-as-a-business-model_b_950806.html
ALL of their smoke and mirrors do nothing for our country except extract and redistribute ALL of the wealth to the top 1%!
They are FINANCIAL TERRORISTS and should receive one way tickets to bernie's cell.
12/12/10
"The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.
Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.
In theory, this group exists to safeguard the integrity of the multitrillion-dollar market. In practice, it also defends the dominance of the big banks.
The banks in this group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market, and they are also trying to thwart efforts to make full information on prices and fees freely available."
http://www.nytimes.com/2010/12/12/business/12advantage.html?_r=1&src=busln&pagewanted=all
derivatives hit $700 TRILLION per the graphic in the article
I hope you read the comments in response to your article because...while this may be a valuable insight to those in the industry, familiar with these terms, I would suggest that a second piece could be written by you for those who are not up to speed on what these things mean but would like to become informed. Many of these terms are new, and seemingly incomprehensible to many. Perhaps a definition of some of the terms, and then a clear account what occurred, who you think in your opinion should be held accountable, and what in your opinion are the risks still out there in a wider context, and how this can be remedied.
Best regards,
I'll be sticking to puts and calls, thank you.