Repo – A New Type of Banking
- A sale and repurchase agreement (“repo”) is a deposit of cash at a “bank” which is short-term, receives interest, and is backed by collateral. Depositor takes legal ownership of the collateral.
- Carved out of Bankruptcy Code; unilateral termination by non-defaulting party.
- Two types of repo: bilateral and tri-party. Both types caused trouble in the crisis.
- Collateral may be “rehypothecated”.
- Collateral value typically exceeds the amount of cash deposited, this is called a haircut For example, deposit $98, receive a bond worth $100—a 2% haircut.
- As of March 2008, the situation at Lehman Brothers was just as precarious as it was at Bear Stearns, and perhaps Lehman only survived longer than Bear because some shady accounting made them look better than reality.
- After the government-supported rescue of Bear Stearns in March 2008, the Federal Reserve created the Primary Dealer Credit Facility (PDCF) to provide liquidity to non-bank dealers like Lehman.
- The PDCF was critical to Lehman’s survival over the next six months, as they tried to get rid of their worst assets and improve their capital and liquidity position.
Lehman Weekend – September 2008
- On September 10, 2008, Lehman reported $28 billion in shareholder equity, $4 billion higher than a year earlier. But it was simply impossible to know if this equity cushion was accurate.
- For one thing, Lehman reported $54 billion in real estate assets. Some market participants thought the true value was closer to half of that, which would effectively wipe out Lehman’s equity.
- At the same time, Lehman’s counterparties in derivatives, commercial paper, and repo were pulling back, shortening terms, and demanding more collateral.
- Most notably, JP Morgan, Lehman’s clearing bank in the tri-party repo market, demanded $5 billion and received $3.6 billion on 9/9, and demanded and received $5 billion on 9/12.
Lehman Weekend – September 12-14, 2008
- Over the weekend of 9/12 – 9/14, the U.S. government tried unsuccessfully to arrange a private rescue for Lehman.
- The government insisted there would be no public money spent on the rescue.
- Bank of America chose to buy Merrill Lynch instead of Lehman.
- On Saturday, Barclays agreed to buy Lehman, but by Sunday the deal was effectively blocked by UK regulators.
- Without sufficient liquidity to operate the next day, and otherwise out of options, Lehman filed for bankruptcy early in the morning on September 15.
- Money-Market Mutual Funds (MMMFs) are a specific type of investment company that is only permitted to own a narrow range of securities. In return for accepting this narrow investment range, they had the right (at this time) to report “stable values” for their share prices.
- On September 16, 2008, Reserve Primary Fund “broke the buck” due to exposure to Lehman Brothers commercial paper. This led to a run on many MMMFs – mostly by institutional investors – and then quickly to an explicit guarantee from the U.S. government.
- We really should have seen this coming – but we did not. Because MMMFs had significant problems in August 2007 as a result of the Asset-Backed Commercial Paper (ABCP) runs.
- McCabe (2010) shows that MMMFs assets under management grew during the ABCP runs of 2007, but that is because the implicit promises of many sponsors were honored: 43 MMMFs were bailed out by their sponsors/fund-families. This level of support was unprecedented.
- In September 2008, this support was not possible, and the resulting runs transferred more than $400 billion from prime MMMFs (which support many components of private finance) to government-only MMMFs (which do not).
- Credit-default-swap (CDS) mark-to-market losses and collateral calls.
- Cash collateral investment losses in securities lending business.
- Funding pressure in CP and repo.
- Ratings downgrade triggers additional collateral calls.
- Liquidity puts on CDOs.
After Lehman, markets are in turmoil and no private rescue is possible.
Fed led rescue of $85 billion, later supplemented by more from Fed and TARP.
The Run on Repo
- $350 billion of short-term funding ran away from ABCP.
- From MMMFs, about the same amount.
- Combine these drains with uncertainty about the subprime exposure on balance sheets, and there is massive pressure on repo markets.
- This pressure manifests in spreads (on underlying ABS), repo rates, and haircuts.
- The statistical evidence in Gorton and Metrick (2012) confirms a significant relationship between LIBOR-OIS and ABS spreads.
- Regression evidence also suggests that the main driver of haircuts was uncertainty about future spreads on the ABS collateral.
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)
MF Global Holdings Ltd. (MF), under investigation by U.S. regulators after filing for bankruptcy protection, violated requirements that it keep clients’ collateral separate from its own accounts, the head of the world’s largest futures exchange said.
Craig Donohue, CME Group’s chief executive officer, said on a conference call with analysts today that MF Global isn’t in compliance with the rules of the exchange and the Commodity Futures Trading Commission.
“While we are unable to determine the precise scope of the firm’s violation at this time, we are investigating the circumstances of the firm’s failure,” Donohue said.
MF Global, the holding company for the futures broker run by former New Jersey Governor and ex-Goldman Sachs Group Inc. Co-Chairman Jon Corzine, is being investigated by regulators for hundreds of millions of dollars that may be missing from client accounts, according to two people with knowledge of the matter.
CME Group’s Chicago Mercantile Exchange is the designated self-regulatory organization for MF Global, meaning it audits and monitors the firm’s positions on a regular basis, said Laurie Bischel, a CME Group spokeswoman.
MF Global told regulators yesterday about deficiencies in accounts that it managed for clients in the futures market, the CFTC and Securities and Exchange Commission said in an e-mailed statement. MF Global was ordered by the CFTC’s enforcement division to preserve records for the review, said one of the people, who spoke on condition of anonymity because the probe isn’t public.
$6.3 Billion Wager
Corzine, 64, now faces a regulatory probe as well as a bankruptcy. He wagered $6.3 billion of the firm’s own money on sovereign European debt in a bid to increase profits. Instead, the firm reported a $191.6 million quarterly loss on Oct. 25 as Europe’s debt crisis led to demands from regulators to boost capital, as well as credit downgrades and margin calls, MF Global President Bradley Abelow said.
BlackRock Solutions, a unit of BlackRock Inc., was called in on Oct. 28 to examine MF Global’s balance sheet and determine if some assets could be sold, according to a person briefed on the discussions. BlackRock ended its review when it became clear the firm wouldn’t find buyers and that there were shortfalls in client accounts, said the person, who spoke on condition of anonymity because the talks were private.
Bobbie Collins, a spokeswoman for BlackRock, declined to comment.
Corzine and Diana Desocio, an MF Global spokeswoman, didn’t respond to e-mails or phone messages seeking comment.
Under the regulations, futures brokers that trade on exchanges are required to keep their clients’ collateral, often cash or securities, separate from their own accounts. The segregated collateral is meant to reduce risk in futures trades. MF Global had almost $7.3 billion in customer funds in segregated accounts as of Aug. 31, according to the most recent CFTC data.
“It’s kind of considered the third rail of the brokerage industry that when you’re holding your customers’ funds in their names, you don’t touch them — even in an emergency situation when you’re running short of cash,” Darrell Duffie, a professor at Stanford University’s Graduate School of Business, said in a telephone interview.
“The fact that the CME has stated that customer funds have been mishandled increases the likelihood that this is not just a simple accounting error or IT glitch,” he said. “The CME obviously has access to its own clearing account records and would probably have based its statement on a review of those records.”
The regulators said in their statement yesterday that they advised bankruptcy as the “safest and most prudent course of action to protect customer accounts and assets.”
The missing funds were reported yesterday by the New York Times. As much as $950 million was thought to be missing at first, and that figure fell to less than $700 million as the firm reviewed its accounting, the Times said today, citing people briefed on the matter. More funds may show up in coming days, the report said.
MF Global listed debt of $39.7 billion and assets of $41 billion in Chapter 11 papers filed in U.S. Bankruptcy Court in Manhattan.
Corzine, who won the top job at Goldman Sachs by leading the firm’s fixed-income unit, was recruited to the firm in 1975 as a trainee on the government bond desk. He graduated in 1969 from the University of Illinois at Urbana-Champaign, served in the Marine Corps Reserve and received his master’s degree in business administration from the University of Chicago in 1973.
Corzine, a Democrat, was elected to the U.S. Senate a year after he left Goldman Sachs in 1999 with an estimated $400 million as the firm went public. He became governor in 2006 and was defeated in November 2009 by Republican Chris Christie.
MF Global’s board met through the weekend to consider options including a sale, a person with direct knowledge of the situation said. The firm was in discussions with five potential buyers for all or parts of the company, including banks, private-equity firms and brokers, a person with knowledge of the matter said on Oct. 28.
Interactive Brokers Group Inc. was still considering a rescue early yesterday, but pulled out after the discrepancy surfaced in customer accounts, The Wall Street Journal reported yesterday, citing unidentified sources.
Thomas Peterffy, Interactive Brokers’ chief executive officer, didn’t respond to a request for comment.
“The first thing you do in any liquidation is go through the accounts and figure out what’s in there and whether they’ve been properly credited,” said Peter Henning, a law professor at Wayne State University in Detroit. “If they say it’s been credited and in fact they’re not there, then you have some very major problems.”
Federal regulators have discovered that hundreds of millions of dollars in customer money has gone missing from MF Global in recent days, prompting an investigation into the brokerage firm, which is run by Jon S. Corzine, the former New Jersey governor, several people briefed on the matter said on Monday.
The recognition that money was missing scuttled at the 11th hour an agreement to sell a major part of MF Global to a rival brokerage firm. MF Global had staked its survival on completing the deal. Instead, the New York-based firm filed for bankruptcy on Monday.
Regulators are examining whether MF Global diverted some customer funds to support its own trades as the firm teetered on the brink of collapse.
The discovery that money could not be located might simply reflect sloppy internal controls at MF Global. It is still unclear where the money went. At first, as much as $950 million was believed to be missing, but as the firm sorted through its bankruptcy, that figure fell to less than $700 million by late Monday, the people briefed on the matter said. Additional funds are expected to trickle in over the coming days.
But the investigation, which is in its earliest stages, may uncover something more intentional and troubling.
In any case, what led to the unaccounted-for cash could violate a tenet of Wall Street regulation: Customers’ funds must be kept separate from company money. One of the basic duties of any brokerage firm is to keep track of customer accounts on a daily basis.
Neither MF Global nor Mr. Corzine has been accused of any wrongdoing. Lawyers for MF Global did not respond to requests for comment.
Now, the inquiry threatens to tarnish further the reputation of Mr. Corzine, the former Goldman Sachs executive who had sought to revive his Wall Street career last year just a few months after being defeated for re-election as New Jersey’s governor.
When he arrived at MF Global — after more than a decade in politics, including serving as a Democratic United States senator from New Jersey — Mr. Corzine sought to bolster profits by increasing the number of bets the firm made using its own capital. It was a strategy born of his own experience at Goldman, where he rose through the ranks by building out the investment bank’s formidable United States government bond trading arm.
One of his hallmark traits, according to the 1999 book “Goldman Sachs: The Culture of Success,” by Lisa Endlich, was his willingness to tolerate losses if the theory behind the trades was well thought out.
He made a similar wager at MF Global in buying up big holdings of debt from Spain, Italy, Portugal, Belgium and Ireland at a discount. Once Europe had solved its fiscal problems, those bonds would be very profitable.
But when that bet came to light in a regulatory filing, it set off alarms on Wall Street. While the bonds themselves have lost little value and mature in less than a year, MF Global was seen as having taken on an enormous amount of risk with little room for error given its size. By Friday evening, MF Global was under pressure to put up more money to support its trading positions, threatening to drain the firm’s remaining cash.
The collapse of MF Global underscores the extent of investor anxiety over Europe’s debt crisis. Other financial institutions have been buffeted in recent months because of their holdings of debt issued by weak European countries. The concerns about MF Global’s exposure to Europe prompted two ratings agencies to cut their ratings on the firm to junk last week.
The firm played down the effect of the ratings, saying, “We believe that it bears no implications for our clients or the strategic direction of MF Global.”
Even by Sunday evening, MF Global thought it had averted its demise after a disastrous week. Over five days, the firm lost more than 67 percent of its market value and was downgraded to junk status, which prompted investor desertions and raised borrowing costs.
Mr. Corzine and his advisers frantically called nearly every major Wall Street player, hoping to sell at least some of the firm in a bid for survival.
On Friday, the asset manager BlackRock was hired to help MF Global wind down its balance sheet, which included efforts to sell its holdings of European debt. BlackRock was able to value the portfolio, but did not have time to find a buyer for it given the other obstacles MF Global faced, according to people close to the talks.
By Saturday, Jefferies & Company became the lead bidder to buy large portions of MF Global, before backing out late in the day.
On Sunday, a rival firm, Interactive Brokers, emerged as the new favorite. But the Connecticut-based firm coveted only MF Global’s futures and securities customers.
While MF Global was resigned to putting its parent company into bankruptcy, Interactive Brokers was also willing to help prop up other MF Global units, including a British affiliate.
By late Sunday evening, an embattled MF Global had all but signed a deal with Interactive Brokers. The acquisition would have mirrored what Lehman Brothers did in 2008, when its parent filed for bankruptcy but Barclays of Britain bought some of its assets.
But in the middle of the night, as Interactive Brokers investigated MF Global’s customer accounts, the potential buyer discovered a serious obstacle: Some of the customer money was missing, according to people close to the discussions. The realization alarmed Interactive Brokers, which then abandoned the deal.
Later on Monday, when explaining to regulators why the deal had fallen apart, MF Global disclosed the concerns over the missing money, according to a joint statement issued by the Commodity Futures Trading Commission and the Securities and Exchange Commission. Regulators, however, first suspected a potential shortfall days ago as they gathered at MF Global’s Midtown Manhattan headquarters, the people briefed on the matter said. It is not uncommon for some funds to be unaccounted for when a financial firm fails, but the magnitude in the case of MF Global was unnerving.
For now, there is confusion surrounding the missing MF Global funds. It is likely, one person briefed on the matter said, that some of the money may be “stuck in the system” as banks holding the customer funds hesitated last week to send MF Global the money.
But the firm has yet to produce evidence that all of the $600 million or $700 million outstanding is deposited with the banks, according to the people briefed on the matter. Regulators are looking into whether the customer funds were misallocated.
With the deal with Interactive Brokers dashed, MF Global was hanging in limbo for several hours before it filed for bankruptcy. The Federal Reserve Bank of New York and a number of exchanges said they had suspended MF Global from doing new business with them.
It was not the first time regulators expressed concerns about MF Global.
By midmorning on Monday, the firm filed for bankruptcy.