Credit Derivatives and Leverage Sank Jon Corzine’s MF Global

By: Janet_Tavakoli

“Repo to Maturity” Transactions Are in Substance Total Return Swaps, a Type of Credit Derivative.
Fallout Is Worse Than Lehman For the Exchange-Traded Futures Markets.

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-tomaturity” 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.

By Janet Tavakoli

web site: www.tavakolistructuredfinance.com

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago's Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).

© 2011 Copyright Janet Tavakoli- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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