One wonders exactly how MF Global was able to leverage themselves so much. Their June financials showed $44.4 billion of assets vs. $1.4 billion of equity, a ratio of just over 30 times. Actually, it is pretty easy. Even with Italian sovereign debt. The answer lies in the repo market.
MF Global participated in the inter-dealer repo market. Direct trades between dealers in that market are traditionally done without haircuts. So if one has Euro 100 mm in market value of an Italian sovereign to finance, you can lend it out and realize the full Euro 100 mm in value. This, in effect, means infinite leverage for the kind of cash & carry trades that MF Global did. The kicker is, of course, that repo trades are margined daily and the liquidity to fund the margin calls has to come from somewhere (assuming you owe the margin). If you run out of cash for margin calls, you go out of business. Stories going around the market claim that the Italian bonds that MF Global bought fell 3 points from where they bought them. If the other bonds fell that much too, that is a lot of margin to pony up. Under that scenario, the accumulated margin calls, $6.3 bio times 3%, were $189 mm, or 13.5 % of MF Global’s equity. When the regulators reportedly told MF Global over the summer that they needed additional capital to support repo margining, this is what they would have been concerned about.
In Europe it in common to use central counterparties for repo trades. They can make repos more balance sheet and capital friendly. LCH.Clearnet’s RepoClear, for example, does charge initial margin (analogous to a haircut) on repos they clear. Like a typical CCP, both sides to a trade pay initial margin. That margin is driven by the maturity of the underlying bond and the length of the trade, with (partial) offsets for opposite repo trades in correlated paper.
MF Global’s Euro sovereign portfolio longest maturity was December 2012, with a weighted average of October 2012. They said that the Euro sovereigns were financed to their maturity. If MF Global cleared their Euro sovereign debt repos through LCH.Clearnet, their initial margin would be well below 3%, possibly closer to 1%. Typically LCH.Clearnet’s trades are very short maturities; overnight out to maybe a couple months – but in any event probably shorter than most of MF Global’s repo to maturity trades. This implies that most of MF Global’s repo counterparties were either other dealers on bilateral trades or MF Global’s clients. In any scenario, the haircuts were going to be low and leverage high.
That is how they can get to 30 times leverage.
(Update: there have been press reports that MF Global may have borrowed money from their FCM client accounts to partially fund the Euro sovereign trades. Other news sources have reported a cash shortfall in the client accounts. We wonder if the next step is connecting the dots between the margin calls on the repo and the “missing” client cash. We hope not…..)