MF Global's accounting practices for its European RTM positions

[IRENA BLAZINCIC]

Hi David,
Repurchase-to-maturity agreement – this is equivalent to long forward contract, basically they agreed to buy European bonds in the future at price equal to par?

Value of RTM agreement = value of long forward = (F - K) exp (-rT)
Where F is forward price today, and K is par value of bond.

But the market price of bonds declined significantly, so forward price F was lower then par, and value of forward contract was negative (and this would have negative impact on P/L)

I don’t really understand the part: “and then used the probability as a factor discounting the valuation of the derivatives.” I guess PWC and regulators don’t understand this too

Are there circumstances where this last step in valuation of forward would be justified?

 

[Juan B.]

Hi,


Note sure if they bought the bond at a future price...I quickly read this morning and what I understood is that they did buy the peripheral countries (plus Belgium) European bonds spot (although levered purchases through margin). In order to avoid mark to market pricing, which causes volatility in the earnings (concerns for the investors) they use them as collateral for long term repos. This is, they offer for example 1% rate for companies who lend money to them and MF leave the bonds as collateral for these loans. If they get anything higher than this 1% of the bonds (which they did), they book a quick profit. As the term of the repo matches the maturity of the bond, according to GAAP is like they were not in their books avoiding this way the MtM. However in the end, they did not got away and they have to reserve capital for potential losses on this portfolio (do not remember if they have to MtM) Anyway, whenever the bonds decrease in value as rate went up, they got margin calls and it seems in the end it was a liquidity crisis, like many other case studies...


I hope it helps to understand it, or more significant, I hope I understood it correctly…


Juan

 

[southeuro]

I like your summary Juan. My only addition would be the operational risk aspect in the MF case, related to their earlier Dooley trade on wheat (he went short breaching the limits and this wasn't picked up by the internal control systems). Another point about the op risk is the friction b/w Corzine and the CRO on the RTM positions.

 

[hamu4ok]

I just wondered why GARP asked us to read only till page 75 of the report on MF Global case, well probably after page 75 interesting conclusions are listed as main causes of MF Global's failure. I Just copied from the contents the titles of paragraphs and labeled them in general terms:

1. Corporate Governance failure: too much power in hands of one person. - Jon Corzine Caused MF Global’s Bankruptcy and Put Customer Funds at Risk,
2. Lack of Cooperation between regulators. The SEC and the CFTC Failed to Share Critical Information about MF Global with One Another, Leaving Each Regulator with an Incomplete Understanding of the Company’s Financial Health
3. Inconsistencies in regulations of SEC and CFTC --> loophole . - MF Global's Use of the “Alternative Method” Allowed the Company to use Some Customer Funds as a Source of Capital for the Company's Day‐to‐Day Operations, Which Subjected Customers to the Risk that MF Global Would Not be Able to Return Those Funds to Customer Accounts Upon the Company’s Insolvency.
4. Inconsistencies in US and Foreign Regulations --> loophole. Differences Between Foreign and U.S. Law Gave Rise to the Potential that MFGI Global Customers Trading on Foreign Exchanges Would Experience a “Shortfall” in Funds Owed to Them, Despite the Fact that Such Funds Were set Aside in Accounts Designated as Secured Accounts
5. Failure of the rating agencies and NY Fed. Moody’s and S&P Failed to Identify the Biggest Risk to MF Global’s Financial Health. The New York Fed Should Have Exercised Greater Caution in Determining Whether to Designate MF Global as a Primary Dealer, Given the Company’s Prior Risk Management Failures, Chronic Net Losses, and Evolving Business Strategy.
6. Firm not telling the whole truth to the regulators. MF Global was not Forthright with Regulators or the Public About the Degree of its Exposure to its European Bond Portfolio, nor was the Company Forthright About its Liquidity Condition.