A closer analysis of the reasons for MF Global’s failure reveals that subtle decisions at the heart of how repo contracts are cleared in Europe may have contributed to the firm’s downfall. Our analysis shows how MF Global could have avoided failure or at least significantly reduced the value of their margin call.
MF Global reportedly financed their Euro sovereign debt using repos to maturity; this was actually pretty smart. Being taken out of a trade because the financing disappeared is a major risk to any leveraged player and MFG covered that one. But differences in how margin is assessed between centrally cleared and bilateral counterparties likely directly contributed to the firm’s failure.
When a repo desk does a bilateral trade, the terms are fixed right then and there. The haircut stays the same for the life of the deal and the only cash moving around during the trade is the variation margin and coupon flows. Master Repo Agreements don’t typically have downgrade triggers and if they do, it isn’t pointed toward the broker/dealer. But when you clear repo trades through a central counterparty like LCH.Clearnet, the rules change. LCH has the right to raise the margin during the life of the trade. According to LCH.Clearnet’s October, 2011 memo to RepoClear members, some of the reasons that additional margin can be demanded are:
* Where a member is downgraded to a credit grade below investment grade
* Where LCH.Clearnet stress testing scenarios highlight increased risk
* Where there is increased concentration or correlation risk in a member’s portfolio
* Where LCH.Clearnet Value at Risk analysis highlights increased risk
* Where Sovereign Credit Risk highlights increased risk
Imagine buying a house and getting a mortgage. The bank tells you you’ll need 20% down. Then, six months later, they demand another 20% because the housing market is weak or you’ve lost your job (or worse yet, that you work in the housing industry and the bank is afraid you’ll be laid off). To prepare for that possibility, the homeowner would need to keep significant reserves available to pay the bank if and when they asked. If the bank doesn’t have the right to make the capital call, the homeowner only needs have sufficient cash to make the monthly payments. These are two very different worlds. A CCP cleared trade is like the mortgage with the bank able to call for additional down payment cash whereas a bilateral trade looks more like a standard mortgage. Granted, this analogy conveniently ignores the realities of daily variation margining. But in MF Global’s case, that may not have been nearly as much of a problem as a sudden call for a bunch more additional margin.
In a December 12, 2011 article in the New York Times, it was reported that “LCH.Clearnet, the firm responsible for clearing the vast majority of MF Global’s European sovereign debt trades, was also demanding $200 million to maintain the positions, atop $100 million it had claimed from MF Global earlier in the week, one person briefed on the situation said.” This sounds like LCH.Clearnet had used their authority to ask for additional initial margin on top of the variation margin called for by changes in the underlying bond values.
CCPs like LCH.Clearnet are a fact of life in the European repo market. But the risk mitigants (in MF Global’s case additional margin) that the CCPs extract come directly out of their member’s pockets, often with the worst possible timing. Cleared longer-dated repos pose a liquidity risk to broker/dealers that must be managed, especially now that regulatory changes are pushing banks to fund for longer periods. The June 2011 ICMA European Repo Market Survey reported that repos greater than six months but less than twelve months went from 3.6% of the market in December 2010 to 6.9% in June 2011. Trades over one year jumped from 1% to 8.7% in the same time frame (although one asks how much of that were the MF Global transactions).
One wonders if regulators might have been convinced last summer that MF Global’s Euro sovereign positions were manageable if their only cash flow exposure during the course of the trade was to variation margin? Maybe not given the oversized nature of the principal position relative to their capital and balance sheet. But MF Global’s cash flow would have been much easier to manage without the need to pay additional margin to LCH. They might have had a chance to stay on the cliff instead of falling off of it.