MF Global and the Risks Looming in the Repo Market

Under Jon Corzine, MF Global was buying European bonds and then using them as collateral for its repo borrowings. Alex Wong/Getty ImagesUnder Jon S. Corzine, MF Global was buying European bonds and then using them as collateral for its repo borrowings.

MF Global employees are the ones responsible for the risky trades that propelled the company toward its demise. But those crippling bets were only possible because MF Global was able to borrow voraciously in a debt market that also played a big role in the collapses of Lehman Brothers and Bear Stearns.

New reports released this week by the MF Global trustees outlined extensive details about the trades, which centered on bonds issued by European governments. The $6 billion of European bets drained crippling amounts of cash from MF Global, hastening its crash. But the firm had no problem putting on these trades just weeks earlier.

This suggests that problems still loom in the repo market, the place where MF Global raised money to pay for its European trades.

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At its simplest, financial firms borrow in the repo market by posting bonds to a so-called counterparty in return for cash. It sounds very safe, since the counterparties, or lenders, get collateral for their loans.

But as recent financial history has shown, dangerous risks can build up in seemingly safe places. MF Global provides a good example.

MF Global was buying European bonds and then using them as collateral for its repo borrowings. The first apparent advantage of this structure was that it effectively paid for itself. While MF Global had to fork out cash to buy the bonds, it could get cash back when it posted the bonds as collateral for the repo loans.

Second, the interest rate it paid on the repo borrowing was less than it received on the bonds. That allowed MF Global to earn a profit that, on paper, could be locked in by structuring the trade in a certain way.

There were two ways that the trade could go wrong. If one of the countries defaulted on the bonds, MF Global wouldn’t have received its money when the bonds matured.

Second, MF Global could get hurt if the repo counterparties – in this case, clearinghouses based in Europe – demanded large margin payments from the firm because the prices of the European bonds securing the repo loans were falling, or because there were fears about MF Global’s creditworthiness. The firm ended up making burdensome margin payments for just those reasons.

The trustees reports make it clear that MF Global executives were foolhardy to pile into these trades. But they would never have been able to do them if the repo market was unwilling to lend to MF Global at an interest rate that made the trade look profitable.

Why does the repo market allow this to happen?

At first blush, it makes no sense for a repo lender to charge an interest rate that is less than the bond they are getting as collateral. After all, the lender could instead go into the market and buy the higher-yielding bond.

Experts point out, however, that a repo lender gets belt-and-suspenders protection, in essence a double safety measure in case something goes south. If the bond underlying the repo defaults, the counterparty still has to make the repayment on the repo. If the counterparty defaults, the lender gets to keep the bond.

It’s a nice theory that may apply most of the time. It becomes particularly flawed, however, when a counterparty is in trouble at the same time the underlying bonds are falling in value.

This was the case with MF Global. The firm was under pressure just as the sovereign debt market was in turmoil.

But the big question is whether repo markets are continuing to ignore the risks at other financial firms that use it to finance their operations.

Repo borrowing across the system is down by a lot since the financial crisis. Generally, safer assets now back the repo loans. And regulators are pressing to make the broader market structure safer.

Given the importance of the repo market, central banks are likely to step in to bail out banks’ repo borrowing again in a global financial crisis. Banks themselves have lengthened their repo loans — from a rough average of three months to around five months, at some firms — to make themselves less vulnerable to repo runs. In addition, they’ve taken steps to more evenly offset the repo loans they borrow with the repo loans they make to other firms, even if poor disclosure makes it difficult for outsiders to discern.

Despite all these improvements, the MF Global reports are an important reminder that the repo market can be a bank’s best friend for years, and then turn around and kill it in days.