(Business Law Currents) With aftershocks reverberating around the world, the global implications of MF Global’s bankruptcy (insolvency) are gradually unraveling, as the intricate world of finance unearths Lehman-esque financial engineering from the American brokerage firm.

Reaping the Benefits of Repos

Despite widespread reporting that MF Global’s downfall was the mistake of a bad bet on Eurozone debts, the truth may have been perhaps more sinister and ironically, rather less risky.

A forensic review of MF Global filings reveals that its sovereign debt exposure may have been part of a series of complex repurchase agreements (known as “repos”) designed to capitalise on the Eurozone crisis but with very little risk – at least by design. Although certainly involving Eurozone sovereign debt positions, it seems that MF Global’s intention may have been less to make a proprietary bet on the future direction of the bonds and instead more akin to a financing position (or liquidity trade).

The $6.3 billion dollars in Eurozone sovereign debt may not have been an attempt to “go long” on Eurozone bonds, but instead were part of an enormous off-balance sheet financing transaction. In short, it was a repo transaction that sought to exploit the difference between the amount received on the bonds and the amount paid under the repo.

Story of MF Global

The failure of MF Global with $41 billion in assets is the eighth biggest bankruptcy in U.S. history – yet it is decidedly European in its origins in more ways than one. Dating back to a sugar brokerage in the City of London in 1783, MF Global has long had a strong association with Europe, having been spun off from UK hedge fund Man Group in 2007. This association with Europe ultimately, however, proved to be its downfall as its sophisticated Eurozone repo transactions proved disastrous.

By way of background, repos are used by many banks as a way to increase liquidity and involve the sale of a security (e.g. bonds) together with an agreement for the seller (the bank) to repurchase the securities at a later date. In return for “selling” the securities, the seller receives a purchase price with an agreement to repurchase the securities at a later date and probably for a greater price – effectively representing the “interest” (known as the “repo rate”). A repo is the economic equivalent of a secured loan with the buyer receiving securities as collateral and the seller receiving the purchase price as the loan principle, although as seen in Lehman Brothers’ collapse, this can be abused for accountancy purposes.

Although its collapse was sudden, MF Global was actually struggling for some time. With a business model partly based on earning interest on its customer funds, the fall in interest rates around the world squeezed MF Global’s bottom line and cut off a line of valuable revenue.

In 2007, MF Global booked revenues of $4 billion from interest it earned on the billions of dollars in customer funds it held against outstanding trades. However, with interest rates approaching near-zero in parts of the world, this figure fell to under $517 million for the 2010 fiscal year.

With core sources of income drying up, enter much maligned CEO Jon Corzine, the former New Jersey Governor and Goldman Sachs CEO, to turn around the business.

Corzine’s solution was to take advantage of a form of financial engineering that keeps risks off the balance sheet, whilst exploiting the Eurozone crisis to the company’s advantage. Not coincidentally, it involved investing in the very types of bonds that Corzine cut his teeth on as a bond trader at Goldman Sachs.

Unfortunately for MF Global, it may have been the unseen nature of these off balance sheet risks that proved so costly for the firm - not unlike the repos that led to Lehman’s collapse. For more information on Lehman’s Repo please see Business Law Currents The Tale of the Grim Repo: Lehman’s Link to True Salesand Legal Opinions and E&Y: The Grim Repo's Next Targets?.

MF Global Repo

Evidence of MF Global’s off-balance sheet acrobatics is buried within the repurchase agreements section of MF Global’s annual report. MF Global states:

The movements in the notional size of these portfolios are the result of the tightening and expansion of spreads in the cash and repurchase markets. When there is less room for spreads between the two markets, there is less opportunity to take advantage of the anomalies in the market. In the year ended March 31, 2011 we expanded our trading in repurchase agreements qualifying for sales accounting as there were opportunities available in the European market. (emphasis added)

These “opportunities” were aggressively pursued by MF Global to write-off around $14.5 billion as “de-recognized” balances for the first quarter of 2011 alone, according to MF Global’s quarterly report. In other words MF Global moved $14.5 billion off its balance sheet and into repos, many of which had Eurozone debt as their collateral. Despite sounding seemingly crazy, the move might have been quite ingenious had MF Global not got quite so greedy.

Rather than serving as a bet that the bonds of Italy, Spain, Belgium, Portugal and Ireland would grow in value, these securities were used to finance around $6.3 billion of toxic Eurozone repos. Using the Eurozone bonds as collateral, MF Global was able to borrow extensively – money it likely plowed back into buying more Eurozone bonds.

MF Global then used the money it received in the form of coupons (interest payments on the bonds) to pay off the interest payments due under the repos, whilst pocking the difference between them.

For example, suppose the interest rate due under the repos (the repo rate) was 1% and the coupon payable under the bonds 4%. This would give MF Global a 3% profit for doing nothing but sitting in between the two trades. Further, provided the bonds paid more than 1% then the cost of the repo would be covered and the transaction would generate a profit with virtually no cost for MF Global.

With the yields on European bonds soaring as a result of the perceived Eurozone instability – Italian bond yields hit 7% this week, MF Global would likely have been inline to pocket a tidy profit if it had held onto the bonds until maturity. The only problem was that MF Global took on the risk that the bonds would default or devalue leaving it with the repo rate shortfall and potentially margin calls.

No Fault in Default

Despite persisting Eurozone problems, the threat of default under the repo transaction would have actually been relatively small- adding further justification for why MF Global pursued this type of transaction so aggressively.

Using a so-called “repo-to-maturity”, the bonds were designed to mature at the same time as the financing did - meaning that the money received from the bonds redemption could be used to pay for the repurchase of the bonds under the repo. Further, with MF Global only investing in short term bonds maturing before 2013, the bonds would have all fallen within the protection guarantee provided by the European Financial Stability Facility (EFSF). The EFSF’s protection added a golden guarantee to the repo and made it far safer than it would have been otherwise.

With the yields on the Eurozone debts easily covering the repo costs, and the collateral covered by the EFSF as guarantor of last resort, MF Global must have thought that it had caught the golden goose. Simply by sitting in between the trades, MF Global could pocket the difference between the bond yields and the repo costs using little, if any, of its own money and with the EFSF guaranteeing the entire transaction. Unfortunately for MF Global it may have overcooked its golden goose by pursuing the strategy a little too aggressively.

Leveraging Kills

Unlike a net long position in Eurozone sovereign debt, the repo transaction actually required MF Global to use very little of its own money. With the repo loan covering the cost of the bond acquisitions and the bond redemptions covering the cost of the repurchase, MF Global could generate returns many times over its initial investment.

For example, suppose MF Global purchased €5 million of Irish bonds. It would then use these same Irish bonds as collateral for a loan of €5 million (or thereabouts) under the repo with an obligation to repurchase the bonds at the end of the repo. When the Irish bonds matured it would be due to receive €5 million - a sum which it would use to pay off the repo at the end of the transaction.

The overall effect is that despite having initially paid €5 million for the Irish bonds, the net economic exposure was negligible. The bonds covered the cost of the repo and vice versa. Transactions of this sort are known as “geared” or “leveraged”, on the basis that they generate benefits (and risks) many times over the amount actually invested.

The only problem for MF Global was that it leveraged itself up an enormous Eurozone sovereign debt position. This leverage created an exposure to the benefits or risks that was many times over its asset base. With no balance sheet constraints (repo-to maturity are generally off-balance sheet), MF Global plowed into a net long sovereign debt position of $6.3 billion- a position that was more than five times the firm’s book value, or net worth.

MF Global’s mistake was that although it wasn’t exposed to the risk of default on the bonds (because of the EFSF guarantee), it still remained exposed to the ongoing costs of maintaining the transaction, such as margin calls, as well as other transactions.

Like Wall Street cocaine, leveraging amplifies the ups and downs of an investment; increasing the returns but also amplifying the costs. With MF Global’s leverage reaching 40 to 1 by the time of its collapse, it didn’t need a Eurozone default to trigger its downfall -all it needed was for these amplified costs to outstrip its asset base.

SEC Shove

With its balance sheet delicately teetering on the edge of a leverage cliff edge, all MF Global needed was a shove to fall to its financial ruin.

The SEC, previously burned by repos that precipitated the collapse of Lehman, noticed in MF Global’s first quarter report the reference to repo-to-maturity transactions. On March 16, the SEC queried MF Global’s accounting treatment in a letter from Senior Staff Accountant Jennifer Monick.

In MF Global’s response to the SEC, which was penned by MF Global’s chief accounting officer Henri Steenkamp, MF Global claimed it was justified in treating repo-to-maturity transactions as sales on the basis that:

“Repo-to-maturity agreements are different from other repurchase agreements in that the repurchase date is the same as the date when the transferred assets mature. We account for repo-to-maturity transactions as sales.”

MF Global’s justification for this was that the repo-to-maturity assets were isolated from the company, the transferee had the right to pledge or exchange the assets and MF Global had relinquished control over the assets.

With the SEC asking questions, FINRA then noticed that certain repurchase transactions to maturity were collaterialised with European sovereign debt and required an increase in net capital pursuant to SEC Rule 15c3-1. With the Eurozone crisis ravaging markets and regulator concerns growing, MF Global moved quickly to increase its net capital coverage of its repos, a fact it duly disclosed to the markets.

According to MF Global’s bankruptcy filings, the SEC then “demanded that MF Holding announce” the full extent of its long position in Eurozone sovereign debt. When MF Global announced that it was long on $6.3 billion in Eurozone sovereign debt, the writing was on the wall.

Admitting to having entered into bets on five different Eurozone countries with UBS, ICAP, Tullet, Garban, together with a number of other banks, MF Global spooked the market, promoting margin calls and a collapse in its share price. As its liquidity drained away, the brokerage firm’s leverage came back to bite, as it found it increasingly difficult to meet short term liabilities, despite the fact that its Eurozone bets had not defaulted.

The cycle became a self fulfilling prophecy, with creditors’ attempts to protect themselves actually pushing MF Global closer to bankruptcy. On 30 October 2011, MF Global filed for Chapter 11 bankruptcy protection. The Eurozone crisis continues.