Nobody knows how many bad assets banks have, the bankruptcy of a broker showed

The sovereign debt crisis in Europe has so far led to only one corporate bankruptcy. But this is a very remarkable story. In November, MF Global, an American broker in the bond, complex instruments and futures markets with assets of about $40 billion, went bankrupt. It was ruined by excessive trust in the policies of the southern eurozone countries.

The company collapsed instantly - literally in a week. At the same time, formally the losses were not too large in relation to assets ($191.6 million in the quarter ended in September). The loss of MF Global shows very clearly what the mechanism of bankruptcy of large European financial institutions can be. And it teaches us that neither stress tests nor increased capital adequacy requirements will prevent it.

This will be the eighth largest bankruptcy in US history. But relative to the largest investment banks, MF Global is small: Goldman Sachs’ assets are about 23 times larger, JP Morgan’s are 56 times larger. At the beginning of 2010, MF Global entered the brokerage elite, becoming (along with GS, Deutsche Bank, Barclays, etc.) one of 20 primary dealers in the US government debt market.

The collapse of MF Global was accelerated many times over by the fundraising mechanism used by the broker. Almost half of them were raised through off-balance sheet repo transactions. This is a push-pull transaction: the buyer (in our case, MF Global) sells a security, agreeing to buy it back at a different price after some time. For accounting purposes, such a transaction is treated as a sale - this is what allows risks to be removed from the company’s balance sheet. Therefore, European risks were not visible from MF Global's reporting and were not covered by its capital.

In pre-crisis times, repo financing allowed MF Global to build a powerful channel for raising money, while simultaneously maintaining its position in European bonds. But the broker's actual dependence on repo financing was significantly higher than the balance sheet shows. During a crisis, this is dangerous: when clients have doubts about the stability of a broker, they reduce its funding; he has to reduce the financing of his clients, who take the free cash balances from the broker, and further in a circle. This is how Matt King from Citibank described the mechanism of Bear Sterns bankruptcy in 2008. MF Global also went exactly this way - it did not have excess liquidity to increase the collateral for the funds raised.

What ruined MF Global was a special type of repo—repo to maturity. Unlike a regular repo, this is a sale of security in which the date of its repurchase coincides with the maturity date of the security. The income of the buyer of paper is the difference between the price at which it is redeemed and the purchase price (which is lower than the nominal price). MF Global's benefit is the coupon paid when the bond is redeemed minus the margin on its sale. In fact, the broker receives free financing and makes a little money on a risk-free (so it was believed) transaction, which is based on sovereign bonds. It is now analysts, one after another, who say that the concept of risk-free assets died in the fire of the sovereign debt crisis - in the summer of 2011 this judgment was still non-trivial.

In the fall, however, it became clear to everyone that sovereign bonds are not risk-free instruments. But Jon Corzine, head of MF Global, was stubborn. Even a week before the bankruptcy, he told analysts on a conference call: “The spread between the cost of financing on the repo transaction and the bond yield remains attractive, while the structure of the transaction eliminates risks.” For its inadequacy, several bloggers suggested making this phrase the epitaph of Corzine, who was co-chairman of Goldman Sachs before working at MF, and then the unsuccessful governor of New Jersey. In the near future, his main focus will be trying to fight off a class action lawsuit from MF Global clients.

MF Global carried out transactions with bonds of Italy, Spain, Portugal, Ireland and Belgium using the described mechanism for $6.3 billion or 15.8% in relation to assets ( ADDED 11/30/2011: as it became known on the day of publication of this text, the rate in European The casino that MF Global arranged for itself was almost double the figure disclosed in the financial statements. MF head Jon Corzine brought it to $11.5 billion, about a third of the broker's assets. And only through various hedging mechanisms did MF reduce the net amount of European risk up to $6.4 billion ). From the broker's point of view, these transactions were risk-free due to their short-term nature: all bonds had to be repaid by 2013. If countries have difficulties, MF Global believed, they will be helped by the EFSF, the European Financial Stability Facility, which should exist until mid-2013. The depth of the broker's faith in Europe is demonstrated by the fact that this volume was hedged by only 1/5 with a short position in French bonds for $1.3 billion.

Berkeley professor Brad DeLong reconstructed the scheme that killed MF Global in two drawings and showed that the deals were much riskier than Corzine thought. For MF Global to win, it was not enough for southern European countries to continue servicing their debt. In addition, the market had to remain tolerant of their risks. If the market’s assessment of southern European risks worsened, then even if the countries serviced the debt, MF Global lost: the cost of financing covered the income received by the broker when the bond was repaid. MF Global's results were even worse if the bonds ceased to be serviced (regardless of how the market valued it).

Thus, DeLong writes, MF Global has made a double bet: Southern European countries will pay off their debts and the market will be tolerant of their difficulties. In the case of Greece, both conditions were not met, and in the case of other countries, the second was not met, and he lost. But the income of the companies that provided MF Global with financing was, in this scenario, higher than if they had simply bought bonds (if, of course, MF Global fulfilled its obligations). On the part of the MF counterparty, the transaction was less risky: a loss only if the bonds ceased to be serviced. If the debt was repaid, but its valuation by the market deteriorated, the gain became maximum (the price of the bonds fell), but if it grew or did not change, the MF Global counterparty won.

DeLong's summary is that from the counterparty side of MF Global, the deal is attractive to those who believe in the countries of southern Europe and are comfortable with volatility, thinking that fluctuations in the capital market do not convey important information. For MF Global, the deal is attractive to "rogue CEOs speculating with other people's money, and those who believe in their ability to move from a leveraged speculator to a well-capitalized investor when necessary." And finally, for those who believe that market perception always keeps pace with fundamentals (that is, who think that without the threat of default, the market will not give up on sovereign bonds).

Seeing that Southern European bonds were becoming cheaper and the risk of default on them was growing, MF Global's counterparties began to demand that it increase the collateral or reduce the raising of funds. This caused a liquidity crisis for the broker. The agencies downgraded the broker's rating, which led to further demands to increase the security of transactions. Meanwhile, bonds continued to fall in price. Corzine’s plans to sell all or part of the business failed: MF Global’s losses continued to grow.

What made this story especially scandalous was that MF Global used client money for its own game in the market. This, according to the bankruptcy trustees, made a hole in the balance sheet by $1.2 billion - so much money that the broker’s 38,000 clients (out of more than 150,000) currently cannot return. Initially, losses were estimated to be half as much, but the estimate changed recently and may still increase. 22% of client funds amounting to $5.4 billion were lost. Among MF Global’s creditors are JPMorgan and Bank of America.

Such operations were prohibited by the American Securities Trading Act of 1934: brokerage firms must separate client funds from their own. Since 2000, brokers have been prohibited from investing clients’ funds (against their will) even in “safe” assets like American government debt. True, brokers could borrow money from client accounts under the repo scheme.

Now regulation will be tightened . Futures market operators will have to insure client funds either using the bank deposit insurance model or by contributing funds to an industry insurance fund. This will be another blow to profits, which for the same MF Global have already decreased by an order of magnitude compared to pre-crisis times (the lower interest rates, the lower the broker’s margin).

MF Global's bankruptcy raises several questions. First, regulators do not know how many similar positions other banks have. Frequently published estimates of how exposed the largest banks are to Greek, Portuguese, Italian and other risks appear to be understated.

Secondly, the auditors did not notice the problem at all, and the rating agencies saw it too late. In endorsing the broker's first-quarter reporting, PricewaterhouseCoopers wrote that the broker had "effective internal controls," not noting that MF Global mixed its own and client money. What is the point of such audit reports and what are they worth, Bloomberg columnist Jonathan Weil rightly asks.

Officials at the CFTC say the company's reporting is in disrepair. This is confirmed by Thomas Peterfay, head of Interactive Brokers Group, who in October thought about buying MF Global and abandoned it. The auditors didn't notice anything. But the same New York office of PwC audits JPMorgan and Goldman Sachs, Weil reminds, and it is much more difficult to notice problems in reporting and control there.

Anatomy of bankruptcy MF Global