We can commiserate with ISDA in their post ”Sad Proof” dated November 7th complaining that the New York Times article entitled ”Sad Proof from Europe’s Fallout”
pinned the fall of MF Global on derivatives. IDSA was factually correct when they wrote “…MF Global did not use derivatives to make its bets on European sovereign debt. As the company stated in its third-quarter earnings release on October 25th: ‘As of September 30, 2011, MF Global maintained a net long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity (repo-to-maturity), including Belgium, Italy, Spain, Portugal and Ireland.’ So it seems clear that MF’s European sovereign debt holdings were just that, bond positions financed via repo transactions. Repos, of course, are NOT OTC derivatives. (They’re also not listed derivatives.) They are basic tools of corporate finance commonly used to finance cash bond positions….”
Now a long cash position + a reverse to maturity does taste a bit like selling protection in CDS form. In the case of the underlying security defaulting, the side doing the ”cash and carry” trade must pay back the entire repo principal and interest, but only realizes the recovery value of the underlying security – not very dissimilar to the cash flows for the protection seller when the reference instrument on a CDS defaults. Repos and CDS (the latter I think we can agree are derivatives) are both typically margined daily and trade using master documents (albeit different agreements and different netting pools). Unlike repos, CDS have a cheapest to deliver option. But repos are not derivatives. Is it fair to wonder if this is a difference without a distinction?
The MF Global implosion does have some teachable moments though. They financed their Euro sovereign paper to maturity. That actually ended up being pretty smart. They did not want to be taken out of their “bet” by losing financing. Much has been written about the systemic risk that the repo markets help transmit (we’ve done our fair share). Financing paper short term means that any hiccup in the system can disrupt the availability of funding and you go bust. Think Drexel and Lehman. MF Global avoided that problem by locking in their funding. The margin calls, well, are a different story.
Because MF Global financed the paper to maturity, FASB rules allowed them to defease the bonds from their balance sheet, leaving them relegated to a footnote in their financials. This sounds a lot like Lehman’s Repo 105, but not exactly. More like a pretty standard interpretation of FAS 125.
Who knows whether the repo to maturity was driven by a.) the desire to veil the bonds on their balance sheet, b.) the acknowledgement that the underlying bonds were risky and locking up the funding was prudent, c.) both or d.) none?