Four months ago, I posted to seminal pieces, namely The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!and The Fuel Behind Institutional “Runs on the Bank” Burns Through Europe, Lehman-Style! that outlined in explicit detail, the path, methodology and cause and effect of bank runs that will emanate from Europe. Any who have not read these two posts, be aware that I consider them a must. For those of you who feel that my posts are too long, I urge you to take the content embedded within them more seiously (both paid and free content), for although verbose, they are proving to be most prescient.
Traditional views on this “bank run model” largely (or more aptly, only) consider individual savers in the form of depositors on the short side (liquid liabilities). It is a run such as this that caused the banking collapse during the US Great Depression. The modern central banking system has proven resilient enough to fortify banks against depositor runs, as was recently exemplified in the recent depositor runs on UK, Irish, Portuguese and Greek banks – most of which received relatively little fanfare. Where the risk truly lies in today’s fiat/fractional reserve banking system is the run on counterparties. Today’s global fractional reserve bank get’s more financing from institutional counterparties than any other source save its short term depositors. In cases of the perception of extreme risk, these counterparties are prone to pull funding are request overcollateralization for said funding. This is what precipitated the collapse of Bear Stearns and Lehman Brothers, the pulling of liquidity by skittish counterparties, and the excessive capital/collateralization calls by other counterparties. Keep in mind that as some counterparties and/or depositors pull liquidity, covenants are tripped that often demand additional capital/collateral/ liquidity be put up by the remaining counterparties, thus daisy-chaining into a modern day run on the bank!
This phenomena essentially discredits the thinking at large and currently in practice that “since individual expenditure needs are largely uncorrelated, by the law of large numbers” banks should expect few withdrawals on any one day. The fact of the matter is that in times of severe distress, particularly stemming from solvency issues (read directly as the Pan-European Sovereign Debt Crisis, and Greece, et. al. in particular), the exact opposite is the case. Individual depositor and counterparty actions are actually HIGHLY correlated and tend to move in tandem, particularly when that move is out of the target fiat bank. They tend to take heed to the saying “He who panics first, panics best!"
Asset/liability mismatch can, at the margin nearly assure a Lehman-style fiasco in the case of an impetus that sparks herding mentality, whether it be among depositors/savers or institutional counterparties.
So, armed with the cause, effect, and path of bank runs coming from Europe, templated by Lehmand and Bear, guess what happend yesterday? As excerpted from FT.com: MF Global and the repo-to-maturity trade
... So, while most of the media has been commonly referring to MF’s sovereign bond positions as proprietary bets gone wrong, there’s more to it than just that. If anything this was a financing position (or liquidity trade) — not a bet on the future direction of the bonds themselves. What’s more, if executed properly the trade should — at least on paper – have posed little or no risk. The maths was simple enough. You account for the cost of borrowing funds using the bonds in question as collateral (the repo rate) versus the ultimate coupon payments received from the very same bonds.
This is because in dysfunctional markets the repo rate can be out of kilter with the ultimate returns of the bond itself. This is especially the case if there are more counterparties willing to provide short-term liquidity in return for rates that beat the nominal risk-free return. In other words to act as pawnbrokers to the market. Alternatively, if you have a good credit standing in the market you may be able to achieve a more favourable repo rate than others. If everyone plays their cards right, MF Global receives financing (or liquidity) at a better rate than the market’s – since they are offsetting the repo charges with the ultimate coupon payments — and the counterparty is rewarded in basis points for holding the bond in the interim.
Gross profit is simply total inflow minus total outflow.
As fixed income guru Moorad Choudhry noted in the “Repo Handbook” such a trade should generally be considered low-risk since the financing profit on the bond position is known with certainty until the bond’s maturity.
...In other words, mark-to-market ought not be a concern. As long as the bond pays out at the price you bought if for (which it will if it is held to maturity), it should not be considered a risky position.
As can be seen from MF Global’s earnings statement, MF was indeed counting on the EFSF guarantee to ensure that this would be the case:
... “Over the course of the past year, we have seen opportunities in short-dated European sovereign credit markets and built a fully financed, laddered maturity portfolio that we actively manage. We remain confident that we have the resources and expertise to continue to successfully manage these exposures to what we believe will be a positive conclusion in December 2012,” Mr. Corzine concluded.
On top of that — just in case an unexpected default risk came its way — MF Global had actually hedged the $6.3bn position with a $1.3bn short French government bond trade.
So what on earth went wrong? Italy and Belgium are, after all, still very unlikely to default before the end of 2012. There is no reason, therefore, why the bonds shouldn’t payout.
Which leaves only the possibility of some skittish repo counterparties suddenly getting cold feet and pulling out (or demanding a greater proportion of over-collateralisation with respect to the loan.
If repo contracts were completely reneged upon, this would not only have left MF with a sudden liquidity issue — especially if they couldn’t find a fresh counterparty — but also with a sudden need to mark-to-market the bonds.
Indeed as Reuters reported on Monday:
Last week, counterparties likely pressed MF Global to post more collateral on derivatives trades and may have started reducing the company’s repo financing lines, market sources said.We’re not sure exactly how easy it is to undo a “repo-to-maturity” trade, but it does leave us wondering who exactly those counterparties might have been.
Update 9.30pm GMT: As Kamekon points out below, in most circumstances — depending on the terms and conditions — repos would be subject to regular margin calls or “loan repayments” which re-establish the original repo ratio. Either way, a fall in the value of the bonds could create a major liquidity drain for MF Global. Though these sorts of liquidity risks should have been accounted for in VaR calculations. Much harder to anticipate would have been a complete disappearance of willing counterparties.
So there you go. The MF Global collapse was fueled (ironically) by ZIRP as clearly predicted here The Ironic, Prophetic Nature of the MF Global Bankruptcy Filing and It's Potential Ramifications, and the straw that broke the camel'sman's back was an old fashioned institutional bank run, as was clearly anticipated many months ago here at BoomBustBlog.
Subscribers, this distrust, collateral calling, back stabbing bank run thing will get much worse before it gets better. I strive to put out quality, not quantity, and I truly believe that those banks and entities outlined in the research reports of the past two months are going to prove to be blockbusters of alpha on the short side. Reference the Commercial & Investment Banks subcategory under "Banks & Financial Services" heading in the subscription content tab. The last three entities covered are again ripe for the picking after the recent bear rally, in the case of a systemic downturn (which I fully anticipate) although I can't guarantee for how long.
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