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.