Submitted by Jeff Snider, President & CIO of Atlantic Capital Management
MF Global Shines A Light On Monetarism's Incapacity To Enhance The Real Economy
The temptation to compare any financial institution’s failure to those that preceded the 2008 crisis and panic are reasonable. It is easy to classify MF Global as 2011’s “Lehman” event, just as it was to use the same term to describe Dexia a few weeks ago. The use of the term “this year’s Lehman” is somewhat misplaced simply because its users are looking for an event that kicks off another crisis or panic. Instead of using “Lehman” to describe a potential inflection point that propels the crisis into panic, it might be better to see MF Global as AIG.
The comparison to AIG is not to say that MF Global was as interconnected, that its failure will be as devastating, or that it is the straw that breaks the European camel’s back. The urge to see the past in the present is historically valid, but it will never be exactly alike (Mark Twain had this right). Rather I think the comparison is useful in that AIG taught the wider world what was really rotten at the core of modern finance, namely hidden risks that were shockingly existential. MF Global’s failure importantly shows that none of the lessons have been heeded in the days since, providing a somewhat unique window into the real dangers that still lurk hidden in the shadows. More than that, though, MF Global demonstrates an obvious shortcoming of the financial system as it relates to the real economy.
ZeroHedge posted the bankruptcy affidavit of MF Global’s President and Chief Operating Officer Bradley I. Abelow, drawing attention to Section E, item 33 on page 13. Mr. Abelow makes the following statement under oath:
“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.” [emphasis added]
The transaction in question was a “repo-to-maturity” financing deal, collateralized with the troubled sovereign European debt that everyone has been talking about in the past few days. What is particularly striking about this is that a “repo-to-maturity” deal is accounted for as a sale, meaning that what is essentially an ongoing collateralized loan is, surprise, hidden off the balance sheet. Maddeningly, MF Global likely booked a profit up front at the transaction’s consummation using obviously faulty mathematical expressions of those “reasonable” expectations of profit, thus avoiding the need to post any liability to the balance sheet.
This makes a lot of sense, then, in why FINRA “demanded” it change its capital treatment of the transaction. Though it was “properly” accounted for according to convention, the risks of collateralizing a loan with questionable debt means that MF Global has ongoing liquidity risk attached to it. As the value of the European debt collateral is questioned, or falls, the lender/cash owner counterparty will ask for additional collateral posting as it applies a stricter haircut to that original, troubled collateral. So, even though this transaction has fully cleared MF Global’s books, the company is still on the hook should it be required to post additional collateral or cash (which ended up with the company in bankruptcy, just like AIG).
The stink here is that this is not an isolated case of cheating (aside from MF Global’s use of client funds). It is a pervasive shadow element to the modern financial system, fully allowed by accounting conventions and regulators. Just like AIG, MF Global was not brought down by bad debt per se, it was brought down by the hidden liquidity risk of the deterioration of off balance sheet arrangements that were allowed by accounting standards. The fact that it was classified as a sale was completely inappropriate in terms of describing the overall liquidity risk of the company, as FINRA belatedly recognized.
MF Global was expressing a bet that it could earn a spread, essentially risk free, on the rate it paid on the repo transaction (the lowest borrowing rate around) and the interest it received on the Euro sovereigns (among the highest rates of the sovereign class), all the while counting on the European politicians and the ECB to provide enough “support” to maintain a relatively constant debt price in order to fool the marketplace into complacency about real risks. So the risk hidden but embedded within the transaction appears long before there is a default, hitting the company once the repo counterparty devalues the collateral (the market was apparently not fooled enough by the ECB’s attempts at price stability). This is the essential financial misrepresentation of the age. Repo accounting is responsible for so much hidden risk, yet it has become central to the ongoing survival of the system as it is currently constituted.
The pliability of how the system is allowed to “book” and account for risk is certainly the driving force making repos so vital to modern banking. For instance, a gold or silver lease arrangement is essentially the same as a repo-to-maturity transaction, yet it is accounted for in exactly the opposite way. A gold lease is really a sale transaction since the physical metal is literally removed from the custody of the gold owner, yet it is accounted for as a collateralized loan where the gold remains on the owner’s books as if it is really there (since it technically involves a repurchase agreement on the back end, even though these deals are simply rolled over in perpetuity and the repurchase never takes place, nor is it intended to). Both gold leasing and the repo-to-maturity transaction are forms of collateralized loans, yet they receive far different treatment so that they accomplish exactly what the banks want to accomplish, which is disguising the real nature of each transaction. The gold lease presents risks in that metal may not be where everyone thinks it is, and the sale treatment of the repo-to-maturity removes haircut and liquidity risks from what are supposed to be transparent statements of condition.
That is why this system has to change at some point. It is exactly designed to be misleading, and the reason is so very simple. In any fractional system there will be a desire to amplify that fraction to the maximum degree. But in doing so, participants recognize that the process of maximization entails creating negative human emotions and perceptions since history is not really that kind to this manner of fractionalization. So the system has institutionalized, abetted by the very regulators that are supposed to cap fractions and leverage, these methodologies of hiding just how much financial entities have engaged in maximizing themselves under the cover of mathematical precision. Trillions in derivatives are no problem because there are powerful and elegant equations to net and hedge them.
Without any sort of exogenous anchor to credit production and banking, risks are theoretically nearly infinite (since the slightest disruption to expected haircuts renders firms utterly bankrupt!), while at the same time there are multiple avenues for misdirection and disguising those realities. The Panic of 2008 was supposed to correct these excesses and remedy the fact that risks have not been accurately priced for decades. Yet the system has resisted every effort, simply settling for redefining the appearance of safety yet again. Somewhere in that mathematical pursuit of maximum fractions, the very goal of finance changed, as if traditional banking was no longer sufficient to support the pursuit’s ever-growing ambitions. So the financial economy has broken away from the real economy, using the ironic cover story of enhancing price discovery to the process of intermediation – complexity is good!
Intermediation is supposed to be about matching the wider (real) pool of savings to worthwhile economic projects that have a real, productive impact on the real economy. MF Global’s repo-to-maturity transaction cannot be fairly classified as real intermediation since the firm knowingly advanced credit to an economically unfeasible obligor with the expectation that the price would never reflect that reality (how’s that for enhancing price discovery). This crystallizes, I believe, just how far the financial system has moved away from real intermediation and reflects the biggest part of the real problems in the real economy – money is no longer productive in economic terms and has not been for decades.
The Occupy Wall Street crowd sees this as a problem with capitalism. I believe that they are correct in their target, but wrong in their diagnosis. This is not a problem of capitalism since Wall Street is a practitioner of monetarism. A real capitalist system works through real intermediation creating positive opportunities for productive enterprises (scarce money is actually vital here). Our current system of repo-to-maturity and gold leasing is nothing but empty monetarism’s habit of regularly forcing the circulation of empty paper. And when the system begins to doubt itself, as it did in 2008, the answer is always about finding a way to restart the fractional maximization process yet again, which means disguising the real risks inherent to that process. There is no real mystery as to why prices and values have seen such a divergence, and why that is a big problem to a system that depends on appearances.
The fact that money is disconnected from the real economy never enters the consciousness of monetarists since money is always the answer. But make no mistake, the primary reasons for this global malaise are that money has lost its productive capacity and its proper place as a tool within the system, not as the ultimate object of that system. MF Global’s failure is an apt demonstration of just how far modern finance has strayed, just as AIG was three years ago.