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MF Global, Repo-to-Maturity and Large Bank OBS exposures
There have been a number of good analyses of the MF Global collapse and the role of “repo-to-maturity” trades in the failure. See “MF Global and Repo Accounting,” which also has links to Felix Salmon and several other good posts. Read Yves Smith’s comment on Lehman Brothers from last March as well.
But one of the things that most people seem to miss in this fiasco is the role of off-balance-sheet or OBS accounting in making the failure of MF Global a reality and, in particular, what it implies for other, larger banks. Many observers say that the FASB erred by not “fixing” the OBS issue via disclosure, but in fact we need to eliminate OBS treatment of all assets, period. Indeed, the MF Global failure suggests that the US and EU banking systems may be facing a far larger problem than even the most bearish analysts suspect.
First let’s ponder a recent report by the International Swap Dealers Association or ISDA. A post on RiskCenter summarizes the findings:
“The counterparty credit risk exposure of 12 US bank holding companies and international banking companies to monoline insurers has led to some $54 billion in write-downs by the banks since 2007, according to a new analysis by the International Swaps and Derivatives Association, Inc. (ISDA). ISDA conducted the study as part of its examination into the losses incurred in the US banking system due to counterparty defaults on OTC derivatives. An earlier paper on the subject, based on data from the US Office of the Comptroller of the Currency (OCC), showed such losses for US banks amounted to only $2.7 billion from 2007 through the first quarter of 2011. After further investigation, it became apparent that the transactions involving subprime mortgage risk taken in synthetic form (via derivatives) were booked in firms outside the US banking system.”
What the ISDA report suggests, oddly enough, is that the large banks which comprise the most important members of the derivatives markets and ISDA both have been under-reporting their losses to monoline insurers by more than 20x in their SEC filings. But the report also confirms in the last sentence the key factoid that should make the blood of Barack Obama, Jamie Dimon and FOMC members run cold, namely that the banks were hiding these losses on RMBS from investors and regulators in OBS vehicles. This is essentially systematic securities fraud, enabled and facilitated by the FASB and ISDA. By relying solely on GAAP accounting, the OCC, Fed and other regulators have left themselves completely in the dark regarding large bank OBS exposures.
So now we come to the MF Global failure and Jon “Superman” Corzine, who followed the familiar pattern of taking a financial and legal template developed in Washington and specifically the Treasury market and extending the model into inferior assets. This is precisely the same behavioral pathology, to my friends Barry Ritholtz and Joe Nocera, which Wall Street used in the subprime crisis. Washington started the game rolling and Wall Street made it better. As Flo and Eddie sang with Frank Zappa and the Mothers at the Fillmore East in June 1971, “so happy together.”
In a “repo to maturity,” banks are permitted to match fund Treasury securities and then lend the securities out. The bonds are not shown on the books of the bank or dealer, because the servile functionaries at the FASB have blessed the repo as a risk-shifting transaction. In economic terms nothing could be further from the truth, but reality has never stopped the FASB from embracing acts of global idiocy like fair value accounting and OBS treatment for RMBS securitizations.
The repo-to-maturity arrangement works with Treasury paper because the Fed stands willing to buy any securities issued by the US government at par, thus the repo has no risk. The problem comes, however, when the financial institution starts to think that it can do these same, repo-to-maturity trades with paper other than Treasury collateral. This is why we need to eliminate the OBS distinction in the US immediately.
What Corzine apparently did at MF Global was to put on repo-to-maturity trades on with non-US, EU government debt. While the post-WWII construct created by the US makes all debt issued by members of the OECD “zero risk” under the Basel accord, this reality is now disintegrating. The sovereigns are now the inferior credits in the global markets, but many large US and EU banks are loaded to the gills with this debt. Unfortunately Corzine did not get the memo. Remember, the OECD is a Cold War construct of the US meant to help defeat the Soviet Union. It has nothing to do with assessing credit risk or even economic capacity to service debt.
So when people ask me about the exposure of US banks to EU governments, the answer is that we do not know because of the FASB and the willingness of US bank regulators to look the other way by accepting GAAP disclosure as sufficient. When JPM, GS and MS tell us that their EU exposure is limited, what they are really saying is that their GAAP disclosed exposures are small. The real risk exposure is, in my view, far larger.
If we could see all of the OBS exposures of the top 10 US banks to EU government via deceptive if for now legal canards such as repo-to-maturity, my sense is that the difference between the reported risk of US banks on EU government debt and the actual risk exposures would be the same as the gap between the OCC’s view of bank risk on monoline insurers and the reality just confirmed by ISDA. Thanks guys.
And just to show we are paying attention, ISDA is wrong to criticize Gretchen Morgenson’s characterization of the MF Global collapse in last Sunday’s New York Times. Cash is cash, but repo-to-maturity is a derivative, just like any trade that involves an ISDA agreement.
So here is the question Morgenson should ask the top bank CEOs: How much exposure to EU government debt does you bank have OBS? I suspect that the reason for the great performance in financials today is that people in the markets have reached the same conclusion. So, to me, we should hit the bid for US large cap financials in the AM regardless of what is happening in the EU tomorrow – or not.
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Anyone who has ever done a bit of mangerial accounting will tell you that deceitful financial reporting is positively encouraged by the rules. For as long as I can remember, I've been ranting about the worst case of the financial authorities giving blow jobs to the mega investment banks: The fact that they do not have to declare off book derivatives. To ANYONE. For some reason, trillions of risk assets are deemed a secret, and everyone turns a blind eye. On the declared P&L and B/S of financial houses, synthetics don't even exist - which is kind of apt. But still, how fucking stupid is that for a system?
This topic comes up every now and then, we rant or nod sagely, then it gets buried and forgotten about, popping up only as speculation about how truly fucked the system might be. Last time the number touted was $200 Trillion for the US. Insane.
Heard a rumor that Barney Frank won't run for Congress next term, but is "plugged in" for a job with the SEC ..... Now it all makes sense.
you naming names?
Shows you the degree to which Gretchen is right the way they went after her. We undoubtedly will see "all of the OBS exposures of the top 10 US banks to EU government" and a lot more besides before this global banking nightmare is over. And we thought it was just Enron!
if the damn gave us a roadmap
http://www.youtube.com/watch?v=8iyDZBAFxKE&feature=related
the failure is not the fight but the idea
No, no, no...do not look at Jon Corzine or Solyndra or LightSquared....all criminal enetrprises that should have the full force of Congress, the FBI, and indeed Occupy Wall St. descending on them.
Look at Herman Cain... a black man who did not attend an Ivy League college, was successful as a businessman, created thousands of jobs....and who is being slandered by a bunch of career "harrassment" accusers.
Why are all the accusers from or connected to Chicago, but Herman Cain has never worked in Chicago?
Yeah - Cain...thats the ticket. Lets forget the fact that he worked for the KC Fed.
Dumbasses...
Barry & gang are just ticked off Herman doesn't need a teleprompter. But, I guess the country needs some sort of jerry sringer type of election, complete with reallity types cursing at each other and pulling their hair while exposing some big cleavage. Or, maybe South Park had it right, New Jersey is really trying to invade the rest of the country and an Army of Snooki's have been sent to hijack everybody, from the crowds of protesters from NYC to Oakland, to the Republican Primaries all the way the Fast and Furious Rah Rah types in our multi-national administration.
Yes all the way to the asylum of finance.
None of it makes even a tad of sense, but Ellen Brown tries to inject some sanity: http://www.youtube.com/watch?v=-Sp8oREsvW0&feature=uploademail
How much louder can you (and many others, Barry, Yves, S Johnson, B Black et al) be on the OBS / OTC issue it until it is formally addressed?
http://www.rcwhalen.com/pdf/StatementbyChristopherWhalen_SBC_062209.pdf
http://www.rcwhalen.com/pdf/CD071309.pdf
http://www.rcwhalen.com/pdf/JSF_Yield_08.pdf
I think you need a taller soapbox my friend...
gs_
"Cash is cash, but repo-to-maturity is a derivative, just like any trade that involves an ISDA agreement."
It's a loan. A loan with shitty collateral, but a loan nonetheless.
Is the BIS waiting in the wings to come to the aid of the Euro by re-valuing Gold and cutting the purchasing power of the USD In half – in a vain effort to prevent IMF$ assets from shutting down completely? Or not??
Uhmmm, I think that ISDA stands for
International Swaps (and) Derivatives Association...
http://www.marketswiki.com/mwiki/International_Swaps_and_Derivatives_Ass....
http://www2.isda.org/
No "Dealer" mentioned in the name anywhere I could find.....
hold that thin bright line. i am with you.
OBS is how Ben percolates his ponzi cash into the system without anyone knowing
Did the banks steal the idea from the government, or vice versa?
Banks = Government, Government = Banks.
I don't understand your question.
Oh really!?
Governments - formerly ruled by kings - have been borrowing from banks to fund wars for centuries.
Banks have owned governments for centuries, nothing hard to understand about that ... that's why there is a revolving door between Wall Str and the Whitehouse.
To clarify: things are so enmeshed that it is pointless to try to differentiate between the political and banking classes ... long gone is the period when a petulant king could assassinate a demanding banker.
These days it is all of the one bed.
Corzine should be in jail...Wonder if he will inhabit the same facility that houses Bernard Madoff - though Rikers would be a fitting venue...
Das ist HeiB.
What a bunch of financial palookas we have running the show in this country (and the world). They got after our gal Gretchen pretty good...gotta figure you're in their cross-hairs, Chris. Stay cool.
A Levitical year of debt forgiveness (not erasure) seems more and more a likely event. 2012?
Great article and thoughts. I'm not so up on financial jargon (especially a lot of the acronyms...hey TD...why not publish a small glossary of terms/acronyms for us lunkheads?), but the piece was very clear to me.
Same shit, different instruments. Sheesh.
THink I'll put on some Little Feat..."Fat Man In the Bathtub". L. George...Zappa protege.
Out.
word is Lowell George got kicked out of Frank Zappa's band because he played a 20 minute guitar solo while forgetting to plug in his amp. Just a rumor of course...
+1 on the glossary idea. Getting most of them in context, but for example, what's ES?
USAF -- 'ES' is the ticker symbol for the e-mini SP500 futures contract that trades on the Chicago Merc. Usually refers to the current front-month contract (ESZ, or December mini SP just now). You'll also sometimes see SP00, which is the 'big' SP500 front-month futures contract.
Wrong to claim they saw sovereigns as zero risk credit. Indeed this article gives too much credence to some type of "original thinking" at the MF. Like all the rest they saw those huge yields and it simply didn't compute as "risk." so they plugged their noses and went hog wild...right up until the FRBNY deep sixed 'em. And that's the real story: what's the FRBNY up to? Sounded overtly political to me..."sending a message" and all
Since Corzine is part of the fraternity of govmt brotherhood, it is hard not to think this was a planned take-down of our commodity market. There was a huge impact on the basic producers throughout flyover country... It might take years to know the full impact on the actual producer...
As someone who has watched from the floor of what was the American Options Exchange to living in cattle country and hearing how many producers lost their positions in frozen accounts, probably losing their ranches and livelihood in the near term, I am watching in horror to see what these criminals have done to our markets.
Too bad Corzine isn't intimately made to understand the meaning of the cattleman's description of the word steer...
Do you have some examples you can talk about. I mean I've been trying to find out about alot of these frozen accounts and how many people have been hurt. I can't believe it was a planned take-down, what gain would they get from it.
http://www.blogtalkradio.com/askshow/2011/11/05/the-andrea-shea-king-show
Here is Ann Barnhardt's interview including commentary by one cattleman whose futures account was frozen for a week taking him from profit to default and no recoverable margin account to start new. Legal? Really?
A couple of posts detailing personal knowledge of those with cattle futures that are feeling the affects can be read here:
http://barnhardt.biz/
What would they get from it? Taking down IBs and independent FCMs drives the remaining client base into the hands of the TBTF!
Nice rant on FASB....the architects of distorted financial reality.
Key take away: HIT the Bid in the AM on financials regardless...Yowsah
Engine of Corruption
And FINRA gave them a pass on this? How? Complicit?
The trades are legal, just stupid.
Excellent piece. Defeasance, which is the subject here writ large, makes sense if and only if, the quality of the securities on both sides of the trade are a true match. As the article points out, disclosure is the only remedy. There is no rational and/or ethical reason to ever sanction off balance sheet transactions. Exactly what killed Enron.
This will be up at ZH tomorrow.
http://english.economicpolicyjournal.com/2011/11/mf-global-bankruptcy-cheat-sheet-where.html
mostly globally fucked
Regulatory failure
All the credible reports suggest a complete failure of regulatory oversight is the factor contributing to losses for investors with MF Global.
It remains to be seen if some small per cent of client money will ever be found and returned to those that trusted the company. Risk is part of any investment choice, but we also expect that the firms we do business with will play by the rules, and that the regulators are on hand to enforce those rules. To see the mountains of evidence piling up that MF Global abused that trust, and that client funds were not segregated, and in fact have even formed a slush fund used by the company, is shocking and certainly puts a lie to the integrity of the entire system.
Consider a comparison of two government enforcement agencies.
- The IRS is famous for the heavy-handed approach to root out and punish those who attempt to break the rules. This includes severe penalties, fines, assessment of interest on amounts payable, seizure of assets, and even imprisonment. As a group, agents of the IRS are known to be relentless, ruthless, and aggressive.
- The SEC charged with enforcement of regulations governing all market action and the participants and institutions in the securities industry. A characterization of their track record would suggest a much lower and almost no intensity in terms of pursuit and punishment of those who would break the rules. There are widely reported instances where the regulators have failed altogether to investigate, prevent, or punish wrongdoing in the market.
The much publicized fraud committed by Bernie Madoff is one perfect example, where a well-connected fund manager ran an open ponzi scheme and was not subject to any investigation even after a whistle-blower repeatedly stepped forward to report it directly to the regulators.
There are regular and repeated examples of many firms that have repeatedly committed atrocious acts of fraud that have been let off with relatively minor fines and no admission of guilt by any of the participants. There is a recurring theme where the intensity of regulatory oversight is inversely correlated with the connections and political clout of the individuals involved. None of these situations are acceptable, nor healthy for the integrity of a free market.
Now the question:
-Is the IRS somehow more attractive for the recruitment of the notorious bastards that have made this organization so effective?
-Or, is it a convenient necessity that the SEC is run by less effective individuals with a far lower performance threshold?
Can it just may be that the two agencies have evolved over time to have such widely divergent standards in terms of executing their mandate? Or, is there a degree of political interference that has restrained the SEC such that connected criminals are granted exceptional leeway and punished to a much lower degree when investigations are concluded?
The SEC is by design intentionally inept, and that it has been arranged exactly so by the powerful mafia elites who are so conspicuously engaged in the plunder of all markets to this day.
There is no surprise that abuse and fraud can occur to the degree that would topple a firm such as MF Global when the regulatory agency empowered to prevent such abuse is monumentally incompetent by design.
The world deserves better. How long can it be until there is a total exodus of money from this corrupted system, lacking in any effective oversight, that now appears to be stealing directly from the investors that it depends on to keep the real economy strong?
www.lemetropolecafe.com
SIPC Insured......IS right on the front door of MF. $500,000 and the rest is lost folks! IF fraud is found to be the cause, there is no recovery. Regulatory failure, you bet there is.
No matter how smart you are, how diligent you are, how connected your contacts are, how much 'homework' you have done...when YOU see a US government insured sanctuary YOU are giving blindfaith and can rest assured that YOUR government is DOING it's job.
Everyday YOU, WE, All of us re-pledge that FAITH when we deposit money in our banks or anywhere where THAT US government STAMP OF APPROVAL is posted for safe and secure activity. Why would you not feel that securities that you place in a safety security box is indeed safe when government sanctioned?
WE have, and have had a government that has failed to do the job that they swore an oath to do. That simple...and the populace has kept it's mouths shut for decades.
We have an administration that has sat on it's hands to stop all of this, and there is talk of electing a "different" administration which wants to cut the hands off completely. TRUE????
Like so much cattle, we elect and re-elect that very people who come from the very industries that have destroyed the American fabric. Like greedy fools, we 401k invest in companies who take our jobs to China and then wine that we lost our job to a Chinese company.
If you are winning, you don't want a damn thing changed. Loose, and you want a war to begin yesterday. To think that any change will happen, that any REAL wrong doing will be punished by your government is, indeed, blindfaith and wishful thinking.
Mothers Live at the Fillmore was one of the best albums ever! The harmonies on "Happy Together" were awesome. I think we played it every night during our card games in college.
that's it...i'm gonna go listen to shut up n play yer guitar
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Y-Y
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sorry it seemed apropo
The deer in the headlights is the taxpayer, who will be paying for this mess till the end of time. We are all debt slaves now.
Industry - gone
Wealth - gone
Education - gone
My poor kids.
Don't worry about leaving your kids burdened with unpayable debts (unless you're talking college loans). This enormous debt pyramid is international in scope and utterly interleaved.
The ongoing defaults now underway in Europe will inevitably spread to the insolvent U.S. financial system and its bought-and-paid-for government. The U.S. will default, most likely through currency collapse, and the debts will be wiped out, as will our grossly inflated and unsustainable standard of living.
In another ten years (maybe much sooner) a Bachelor of Arts degree will be a worthless piece of paper. Make sure your kids have valuable skills. There will always be demand for people who can rebuild fuel injectors or do structural welding or farming. Counseling gender issues, not so much.
A liberal arts BA is already worthless without a graduate degree and even then....good luck in these times. College loans: the new subprime for bankers to feast on, and they nailed their profits by eliminating those loans from bankruptcy protection. Sly bastards.
ISDA..
Doesn't that stand for Institutional Swindling and Depradation Alliance?
You sugget Corzine was incompetent.
Many would argue he was well-aware of this distinction, and was simply greedy.
Incompetent like the GAAP disclosure. I think Corzine new precisely what he was doing.
Anyone gonna walk in his office and call him a Phuck up? I didn't think so. Worse still for an ambitious DA he's your ticket to "moving up day." next Goldman Sachs? As John McEnroe would scream "you cannot be serious."
Where is the money? In this case the clients item line account, such as T Bills, PM certificates, etc.
This mysterious last minute lender who demanded collateral from MF, has made off with the bundle, liquidated it and is now sitting in Georgetown on Grand Cayman, smoking a big fat Havana!
So at last count some 650 millions (so far) is missing from client accounts. Sooner or later somebody is gonna talk. Right up to moments before declaring bankrupcy, MF was paying their London traders some hefty bonuses? Could this be 'hush' money? Off load the shady/dirty business off-shore to the "City" to make the trail disapear?
If this rotten, putrid, stinking, criminal mess is not throughly investigated and those responsible see the 'inside' for an extended period of their lives, then kiss your assets goodbye forever.
Its time to break out the "ball breakers"! Mr. Black we need you!
Great report - but begs the question who reversed in the collateral to maturity, allegedly at a lower rate than the bonds?
If they keep using mark to unicorns accounting; sooner or later people will realize that unicorns are scarce.
I suppose mark to Leprechauns is next, as reality has only arrived on main street to date.