What caused MF Global’s downfall?
According to Bradley Abelow, MF Global’s Chief Operating Officer, much of the blame may lie with Finra’s
unreasonablerequest for MF Global to add capital to support its off-balance sheet exposure to European sovereign debt and reveal them publicly. These were, as we have discussed, structured as repo-to-maturity trades. They were also maintained off-balance sheet.
In a personal declaration filed in Chapter 11 proceedings (H/T Zerohedge), Abelowwrites:
As a global financial services firm, MF Global is materially affected by conditions in the global financial markets and worldwide economic conditions. On September 1, 2011, MF Holdings announced that FINRA informed it that its regulated U.S. operating subsidiary, MFGI, was required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MFGI increased its required net capital to comply with FINRA’s requirement.
Upon this notice, Moody’s got a little skittish. As Abelow notes:
On October 24, 2011, Moody’s Investor Service downgraded its ratings on the Company to one notch above junk status based on its belief that MF Holdings would announce lower than expected earnings.
But that wasn’t good enough for Finra. They wanted the exact details of the trades revealed publicly in MF Global’s October results:
On October 25, 2011, MF Holdings announced its results for its second fiscal quarter ended September 30, 2011. The Company revealed that it posted a $191.6 million net loss in the second quarter, compared with a loss of $94.3 million for the same period last year. The net loss reflected a decrease in revenue primarily due to the contraction of proprietary principal activities.
Dissatisfied with the September announcement by MF Holdings of MFGI’s position in European sovereign debt, FINRA demanded that MF Holdings announce that MFGI held a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity, including Belgium, Italy, Spain, Portugal and Ireland. MF Holdings made such announcement on October 25, 2011. These countries have some of the most troubled economies that use the euro. Concerns over euro-zone sovereign debt have caused global market fluctuations in the past months and, in particular, in the past week. These concerns ultimately led last week to downgrades by various ratings agencies of MF Global’s ratings to “junk” status. This sparked an increase in margin calls against MFGI, threatening overall liquidity.
This brought attention to MF Global’s precarious liquidity exposure to the likes of the CFTC and SEC, pushing MF Global into seeking out alternative arrangements before its liquidity position became too precarious:
Concerned about the events of the past week, some of MFGI’s principal regulators – the CFTC and the SEC – expressed their grave concerns about MFGI’s viability and whether it should continue operations in the ordinary course. While the Company explored a number of strategic alternatives with respect to MFGI, no viable alternative was available in the limited time leading up to the regulators’ deadline. As a result, the Debtors filed these chapter 11 cases so that they could preserve their assets and maximize value for the benefit of all stakeholders.
Specific to everyone’s concerns were, of course, were MF Global’s ‘repo-to-maturity’ sovereign debt trades.
Anyone following MF Global’s regulatory notices would though have been able to spot their disquiet early on.
On September 1, for example, MF Global filed the following:
As previously disclosed, the Company is required to maintain specific minimum levels of regulatory capital in its operating subsidiaries that conduct its futures and securities business, which levels its regulators monitor closely. The Company was recently informed by the Financial Industry Regulatory Authority, or FINRA, that its regulated U.S. operating subsidiary, MF Global Inc., is required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MF Global Inc. has increased its net capital and currently has net capital sufficient to exceed both the required minimum level and FINRA’s early-warning notification level.
The Company does not believe that the increase in net capital will have a material adverse impact on its business, liquidity or strategic plans. In addition, the Company expects that its regulatory capital requirements will continue to decrease as the portfolio of these investments matures, which currently has a weighted average maturity of April 2012 and a final maturity of December 2012.
Regulators’ concern no doubt centred around the fact that such off-balance sovereign positions could pose very real and sudden liquidity issue in terms of margin calls. They were probably also conscious of such things as Lehman’s notorious Repo 105 arrangement.
From Note 4:Securities sold under agreements to repurchase $14,380,145,100 (1)(1) includes $7,497,154,700 collateralized with European Sovereign debt and transacted with an affiliateAnd from Note 11:The Company entered into repurchase agreements with an affiliate that are collateralized with European Sovereign debt. The affiliate identified the market opportunity and manages the collateral associated with these transactions, although the Company retains the issuer default and liquidity risk. For these services the Company paid a management fee to the affiliate. The management fee represents approximately 80% of the trade date gain recognized by the Company from entering into these repurchase agreements.
(D) Sovereign debt is subject to the following limits: a futures commission merchant may invest in the sovereign debt of a country to the extent it has balances in segregated accounts owed to its customers denominated in that country's currency; a derivatives clearing organization may invest in the sovereign debt of a country to the extent it has balances in segregated accounts owed to its clearing member futures commission merchants denominated in that country's currency.
(2)(i) In addition, a futures commission merchant or derivatives clearing organization may buy and sell the permitted investments listed in paragraphs (a)(1)(i) through (viii) of this section pursuant to agreements for resale or repurchase of the instruments, in accordance with the provisions of paragraph (d) of this section.(ii) A futures commission merchant or a derivatives clearing organization may sell securities deposited by customers as margin pursuant to agreements to repurchase subject to the following:(A) Securities subject to such repurchase agreements must be “readily marketable” as defined in §240.15c3–1 of this title.(B) Securities subject to such repurchase agreements must not be “specifically identifiable property” as defined in §190.01(kk) of this chapter.(C) The terms and conditions of such an agreement to repurchase must be in accordance with the provisions of paragraph (d) of this section.(D) Upon the default by a counterparty to a repurchase agreement, the futures commission merchant or derivatives clearing organization shall act promptly to ensure that the default does not result in any direct or indirect cost or expense to the customer.
(ii) Repurchase agreements . For purposes of determining compliance with the concentration limits set forth in this section, securities sold by a futures commission merchant or derivatives clearing organization subject to agreements to repurchase shall be combined with securities held by the futures commission merchant or derivatives clearing organization as direct investments.(iii) Reverse repurchase agreements . For purposes of determining compliance with the concentration limits set forth in this section, securities purchased by a futures commission merchant or derivatives clearing organization subject to agreements to resell shall be combined with securities held by the futures commission merchant or derivatives clearing organization as direct investments.
(d) Repurchase and reverse repurchase agreements . A futures commission merchant or derivatives clearing organization may buy and sell the permitted investments listed in paragraphs (a)(1)(i) through (viii) of this section pursuant to agreements for resale or repurchase of the securities (agreements to repurchase or resell), provided the agreements to repurchase or resell conform to the following requirements:...(12) The agreement makes clear that, in the event of the bankruptcy of the futures commission merchant or derivatives clearing organization, any securities purchased with customer funds that are subject to an agreement may be immediately transferred. The agreement also makes clear that, in the event of a futures commission merchant or derivatives clearing organization bankruptcy, the counterparty has no right to compel liquidation of securities subject to an agreement or to make a priority claim for the difference between current market value of the securities and the price agreed upon for resale of the securities to the counterparty, if the former exceeds the latter.
(9) For purposes of §§1.25, 1.26, 1.27, 1.28 and 1.29, securities transferred to the customer segregated account are considered to be customer funds until the customer money or securities for which they were exchanged are transferred back to the customer segregated account. In the event of the bankruptcy of the futures commission merchant, any securities exchanged for customer funds and held in the customer segregated account may be immediately transferred.
(f) Deposit of firm-owned securities into segregation. A futures commission merchant shall not be prohibited from directly depositing unencumbered securities of the type specified in this section, which it owns for its own account, into a segregated safekeeping account or from transferring any such securities from a segregated account to its own account, up to the extent of its residual financial interest in customers' segregated funds; provided, however, that such investments, transfers of securities, and disposition of proceeds from the sale or maturity of such securities are recorded in the record of investments required to be maintained by §1.27. All such securities may be segregated in safekeeping only with a bank, trust company, derivatives clearing organization, or other registered futures commission merchant. Furthermore, for purposes of §§1.25, 1.26, 1.27, 1.28 and 1.29, investments permitted by §1.25 that are owned by the futures commission merchant and deposited into such a segregated account shall be considered customer funds until such investments are withdrawn from segregation.
Description of Tri‐Party Repo Market
The tri‐party repo market is large and important, but not very well understood. It represents a significant part of the overall U.S. repo market, in which market participants obtain financing against collateral and their counterparties invest cash secured by that collateral. Large U.S. securities firms and bank securities affiliates finance a large portion of their fixed income securities inventories, as well as some equity securities, via the tri‐ party repo market. This market also provides a variety of types of investors with the ability to manage cash balances by investing in a secured product. The “tri‐party” label refers to repo transactions that settle entirely on the books of one of two “Clearing Banks” in the U.S. market: Bank of New York Mellon (BNYM) and JP Morgan Chase (JPMC). The Clearing Bank is thus a third party involved in the repo transaction between a “Dealer” (party, not necessarily a Broker‐Dealer, borrowing cash against securities collateral) and a “Cash Investor” (party lending cash against securities collateral). 1
The attractiveness of the tri‐party repo market is driven by the treatment of repurchase transactions in bankruptcy, the use of securities as collateral (including daily margining and haircuts), and the custodian services of the Clearing Banks which provide protections that do not exist for bilateral repo investors or unsecured creditors. As a result, the U.S. repo market contributes significantly to the liquidity and efficiency of the U.S. Treasury and Agency (including Agency MBS) securities markets, which collectively make up approximately 75% of the total collateral in the U.S. repo market. The importance of the U.S. repo market is underscored by the fact that it is the market in which the Federal Reserve operationally implements U.S. monetary policy.
Whether or not tri-party repurchases and resales are permitted for investments of customer funds under Rule 1.25 is unknown, but they would certainly be available to MF Global using its own money. A timely article also published by the New York Fed highlights a current quirk of the US tri-party repo market (repo being generalized for both repurchases and resales), the resolution of which has been delayed, and also points out a key bankruptcy provision (emphasis ours):
The Unwind Defined
The centerpiece of the current reform effort is the elimination of the wholesale daily unwind of tri-party repos, on both maturing and continuing term trades. The unwind consists of an extension of credit to a dealer by its clearing bank to facilitate the settlement of the dealer’s repos (for more details, see this New York Fed staff report.) The clearing banks return cash to cash investors and collateral to dealers each day and, in the interim, extend credit to dealers against their entire tri-party repo book. This unwind temporarily transfers the risk of a dealer’s default from cash investors to the clearing bank. When new repos are settled and continuing term trades are re-collateralized, the exposure to the dealer is transferred back from the clearing bank to cash investors (including new investors).
Why Eliminate the Unwind?
In a recent blog post, I argued that eliminating the wholesale unwind of tri-party repos could reduce fragility in that market. The delays in the reforms, however, leave the market just as vulnerable to the risk that a clearing bank might refuse to unwind a dealer’s trades as it was during the recent financial crisis. If a clearing bank refused to unwind a dealer’s repos, the dealer would almost certainly be forced into bankruptcy, because the dealer would probably not be able to attract new funding that day. That event could create instability in the tri-party repo market that could in turn spill over into other markets. While this risk is not new, its continued existence remains a serious concern.
Part III - An ominous letter written by MF Global
As a general matter, we applaud the CFTC for seeking new ways to ensure the safety and liquidity of investments made by futures commission merchants under CFTC Rules 1.25 and 30.7. However, as we set forth below, we believe the specific amendments being proposed: (a) are unnecessary, considering that the current permissible investments under Rule 1.25 have not, to our knowledge, resulted in any FCM's inability to provide customers their segregated funds upon request or to continue as a solvent entity, (b) will, in many cases, create new investment risks and logistical difficulties for FCMs, and (c) may well change the pricing dynamics for customers and the industry at large. Recognizing the CFTC's concerns, however, we have set forth our own proposed amendments which we believe satisfy the CFTC's desire for the enhanced security of customer segregated funds without the risk of significantly increasing costs to customers.
B. The Investments Currently Permitted Under Rule 1.25 Have Not Put CustomerFunds at Risk.We believe strongly that the CFTC's proposed amendments endeavor to "fix something that is not broken." Indeed, the evidence is clear that the investments permitted and safeguards required under Rule 1.25 have met the CFTC's stated "objectives of preserving principal and maintaining liquidity" of customer segregated funds. Sec Rule 1.25(b). Among other things, since the CFTC's 2004 expansion of permissible investments under RuIe 1.25, we are not aware of any FCM that has been unable to liquidate and provide to their customers upon request any segregated funds invested under Rule 1.25 (or under Regulation 30.7 either, for that matter).4Further, since this expansion, no FCM to our knowledge has failed or otherwise been unable to meet any other of its financial obligations as a result of investments made under Rule 1.25.5 In short, we believe the current investment criteria set forth under Rule 1.25 have worked, including over the past two years of market instability and uncertainty - the ultimate stress test. Nevertheless, the Commission has proposed changes so sweeping that they may in fact increase systemic risk by imposing new burdens on otherwise effective, efficient and liquid settlement processes. Such a radical overhaul, in our view, is unnecessary considering the Rule's stellar track record. At most, the CFTC should be adjusting only slightly the products, counterparties and concentration percentages currently permitted. 6
d. Repurchase and Reverse Repurchase TransactionsThe CFTC proposes to reduce counterparty concentration limits on reverse repurchase agreements to 5% of an FCM's portfolio (currently there are no limits), citing the potential credit risk posed to FCMs by investing a substantial portion of their funds with one counterparty. In our view, this proposal will unnecessarily restrict a very liquid and secure investment that has provided important flexibility as well as reasonable returns for FCMs and their customers. We believe the CFTC should focus on the critical fact that the customer segregated account and the secured amount will be fully collateralized with qualified Rule 1.25 products at all times, even in the event of a counterparty default on a reverse repurchase agreement.Commission and clearinghouse rules require that FCMs routinely transact and fund margin requirements involving large transactions executed against considerable time constraints, often on an intra-day basis. However, the CFTC's proposed concentration limits could severely undermine an FCM's ability to meet these obligations efficiently, thereby creating particular risk for intra-day funding requirements. The CFTC should recognize that imposing a 5% counterparty concentration limit would (a) require FCMs to have relationships with a minimum of 20 (and as many as 25 or more) different counterparties, which would at best be difficult to manage, and would significantly increase systemic risk, and (b) decrease liquidity and increase operational risk, due to a significant increase in the number of required transactions and the resulting potential fails. We believe that introducing these new risks is unwarranted, especially as there is no evidence that any FCM has been unable to timely return customer funds or meet margin requirements as a consequence of investing customer funds with a limited number of reverse repurchase counterparties.We also believe the CFTC's proposed prohibition on in-house and affiliate repurchase and reverse transactions is unnecessary because such transactions (a) may only involve Rule 1.25-permissible securities, (b) are conducted within a regulated entity and, (c) are contained within properly titled Rule 1.25 segregated accounts, as are the related cash and security movements. Eliminating these transactions is inconsistent with the CFTC's stated objective of reducing FCM investment risk, since FCMs would be unable to enter into and execute such transactions with and through entities and personnel with whom they have created an effective, efficient and liquid settlement framework.Consequently, we recommend that FCMs not be subject to a 5% counterparty concentration limit on reverse repurchase transactions, and that they continue to be able to enter into repurchase and reverse repurchase transactions with affiliates and on an in-house basis. However, to the extent the Commission continues to be concerned with the safety of such transactions with unaffiliated third parties, we recommend that it consider (a) limiting FCM repurchase and reverse repurchase transactions to those external counterparties maintaining a certain level of capital (such as $50 or $100 million), or (b) reducing the counterparty concentration limits to only 25% per counterparty.
Conference call on topics relating to the Regulation 1.25/30.7 rulemaking including MMMFs, asset-based and issuer-based concentration limits, counterparty concentration limits, in-house transactions and repurchase agreements with affiliates.
(i) First Lien on Unencumbered Property. Pursuant to § 364(c)(2) of the Bankruptcy Code, a valid, binding, continuing, enforceable, fully perfected first priority lien on, and security interest in, all tangible and intangible prepetition and postpetition property in which the Debtors have an interest, whether existing on or as of the Petition Date or thereafter acquired, that is not subject to valid, perfected, non-avoidable and enforceable liens in existence on or as of the Petition Date (collectively, the “Unencumbered Property”), including, without limitation, any and all avoidance actions, unencumbered cash, intercompany indebtedness owed by one or more non-debtor entities to either or both Debtors (including, without limitation, any and all amounts owed by MF Global Inc. to each Debtor), accounts receivable, inventory, general intangibles, contracts, securities, chattel paper, owned real estate, real property leaseholds, fixtures, machinery, equipment, deposit accounts, patents, copyrights, trademarks, tradenames, rights under license agreements and other intellectual property, capital stock of the subsidiaries of each Debtor and the proceeds of all of the foregoing; provided that, the Debtors shall not be required to pledge in excess of 65% of the capital stock of their direct foreign subsidiaries or any of the capital stock or interests of indirect foreign subsidiaries (if adverse tax consequences would result to the Debtors) or other assets that would be unlawful to pledge as determined by a final order of a court of competent jurisdiction; and provided, further, that the Court will reconsider at the Final Hearing (defined below) both the grant of liens on avoidance actions and whether the superpriority administrative claim shall be applicable to proceeds of avoidance actions, solely with respect to any further authorization to use Cash Collateral in excess of amounts authorized to be used pursuant to this Order.
Senior LienJPMorgan Chase, based in New York, was given a senior lien on all MF Global's available assets in exchange for letting it use $8 million in cash collateral during the company's first day in bankruptcy court.Wilmington Trust has taken over from Deutsche Bank AG, which resigned, as trustee to more than $1 billion in unsecured notes. Other unsecured creditors include Headstrong Services LLC, owed $3.9 million, New York-based law firm Sullivan & Cromwell LLP, owed $596,939, and Oracle Corp., owed $302,704.JPMorgan Chase was also given rights to what a judge said may be the only asset for unsecured creditors: so-called avoidance actions, the lawsuits that let creditors win back assets transferred out of the estate 90 days before its bankruptcy filing. The judge said he doesn't usually permit such extraordinary rights for a lender, and left the door open to re- evaluate JPMorgan's request at a Nov. 14 hearing.