You remember him – he was the Goldman Sachs whiz kid who decided he no longer wanted to “Do God’s Work” and would rather run New Jersey and empty out its treasury. If you see a picture of him, he could be the twin brother of Ben Bernanke. Never trust your money to a person with a beard.
Since leaving New Jersey, Corzine has been running MF Global, a relatively small Broker Dealer firm that dabbles in deriviates in hedge fund. Both Moody’s and Fitch downgraded their bonds this week to junk quality.
In the last quarter, the company had a GAAP net loss of $191 million. The company had net revenue of $205 million, of which it paid out $133 milion to its 2,894 employees, an average of $15k per month. [Are you listening, Occupy Wall Street?]
MF Capital is in trouble over a thing called a Repurchase Agreement (REPO for short). Here is how it works, more or less:
Mythical Bank of Fredonia owns a 10 year bond issued by Greece. The bond has a face value of $1 million. Greece will pay back the $1 million in 10 years, and pay the stated interest rate on the bond (probably 5%ish) during those 10 years. But everyone knows, there was no chance in hell Greece was going to pay that bond back, so the value drops. Mythical Bank bought the $1 million bond for $600,000 a year ago hoping for a miracle or some sucker who will buy it for more.
Monday is the day the auditors count up what’s in the vault to see if Mythical Bank is “safe enough”. The President of Mystical Bank knows they are holding this Greek bond that is now illiquid and has lost $200,000 in value, and if they admit that, they’re in big trouble.
Enter the so-clever repurchase agreement. Mythical Bank approaches a desperate firm and has an offer – tell you what – I’ll “sell” you my $1 million greek bond, and you pay me $490,000 cash. I PROMISE (double cross my heart) that in a week, I’ll buy the bond back from you for $500,000 – you make $10k for doing basically nothing. We won’t actually change the name of the owner on the bond because in a week, I will buy it back. Deal?
So the Auditor shows up on Monday and looks in the safe. He sees $490,000 in cash and not a single bad loan to Greece! Job well Done! The Repo Agreement is sitting in another safe under the CEO’s desk (hiding the REPO would now be illegal, maybe). The bank is declared really healthy and everybody is happy! After the week, the bad bond goes back on Mythical Bank’s books that nobody ever sees – and Jon Corzine takes his $10k profit, and pays out $7k in bonuses to his employees.
Isn’t Investment banking a great thing! It’s almost like making your own money from your own printing press!
EXCEPT – there is one problem with that Repo Agreement – it depends both on the credit worthiness of the issuer (Greece) and the credit worthiness and reputation of the counter party (Mythical Bank).
So now that $490,000 bond is worth only $350,000 in a week . The Repo term ends and its’ time to reverse the deal. Mythical Bank says “What deal?” There is no deal like that. You must be confused. Sue us”. So now the entity holding the bond has a $140,000 loss instead of a $10 profit. Sure, if they take the bank to court, they may win in a year or two, maybe not. Perhaps neither party wants a jury to hear what a REPO agreement is and splash the details in front of Conressional hearings. (Trust me, the US Treasury knows all about REPO agreements and so do the Congress people on the finance committees)
So the entity “holding the bag” in the “pigeon drop” only realistically has the option to try to unload the worthless bond and try to get something back. Legitimate REPO agreements (if that isn’t an oxymoron) should only be done with the highest quality collateral and with a counter party who isn’t going to back out of the deal or declare bankruptcy – in which case there will be chance of recovery.
So MF Global is holding a large quantity of REPO agreements in very shaky European debt (with undisclosed counter parties). Where did MF Global borrow the cash to buy those REPOR agreements? FDIC insured Bank of America, CitiGroup and JP Morgan bought those bonds that are now rated as junk.
MF Global has lost 70% of its value in a week. If it fails (which seems probable), then those three banks will lose their money…. and so it goes.
Thank you for the great explanation. I appreciate your ability to put these financial stories into layman’s terms. The mainstream news either ignores these stories or doesn’t understand them well enough to explain, and the financial press either pulls punches or provides a technical explanation meaningful only to insiders. It’s farcical the way the media is covering the European debt crisis, broadcasting the EU’s daily press release as truth.
I’m not 100% sure I have the Repo explanation totally correct.
I remember a while back John Batchelor (or maybe it was Glenn Beck) asking Larry Kudlow about the issue of how Repos are used to allow the Federal Reserve to indirectly buy up US Treasuries (this was before they started just doing it directly and admitting they were going to give unlimited credit to Tim Geithner).
http://www.newyorkfed.org/aboutthefed/fedpoint/fed04.html
What happens is the New York Fed each day goes out into the Repo Market and buys up Treasury Bonds on short term REPOs, or does a reverse REPO where it loans out the US Treasury Bonds it owns.
These are done using the network of “Primary Dealers” in US Treasuries, a select list of large financial entities, about half of which are not based in the United States. Last time I looked, the average amount that the Fed is lending to its primary dealers each night was about $1 trillion.
So before QE1 and QE2 broke the “Don’t monetize the debt”, the workaround was…. the US Treasury would sell the bonds, Goldman Sachs or another Primary Dealer would buy them, then they would “lend” the US Treasury bonds to the New York Fed overnight in perpetuity. Goldman gets the money to buy the US Treasury bonds in the first place by using money it borrowed from the Fed for 0% interest – earning the interest on the Repo essentially for nothing, other than the risk that the US Treasury bonds might default, in which case they’re out of business in any case.
S&P downgrading the US Bonds below AAA left the Repo market with a problem, since being AAA is one of the criteria for a reliable trade in the repo market.
In response to that question, Kudlow blew the question off – saying it was just the ordinary way business is done with the Federal Reserve, and there is nothing suspect about it. Whoever, asked that question then just moved on. I don’t trust Kudlow further than I can throw him.
The fed has pulled the plug on MF, and bankruptcy filing is expected today
Wish I’d snapped a pic of one of the Obama/Corzine billboards from the 2009 gubernatorial campaign — they made quite a pair!
Thank you so much, that made it much easier to understand. I also like the Fredonia reference 🙂
I am not a Wall Street Lawyer nor an expert in bankruptcy law… But it sounds like JP Morgan is in control of the process of unwinding MF Global.
There is a significant historical irony here. One of the reasons the Federal Reserve and FDIC insurance was created in the first place was that JP Morgan was playing a large role in preventing banking panics and didn’t want all of that risk on their shoulders and neither did the US Government.