Hard lessons from MF Global

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Business Times - 09 Nov 2011

Hard lessons from MF Global

US financial institutions are not impervious to euro shocks

WHO are you going to believe - me or your own lying eyes? That old line from the Marx Brothers came to mind last week as brokerage firm MF Global was felled by over-the-top leverage and bad derivative bets on debt-weakened European countries. Suddenly, all of those claims that American financial institutions have little to no exposure to Europe rang hollow.

You can understand why Wall Street wants to play down the threats from Europe. Its profits depend on the market's confidence in the products it sells - and on the belief that the firms that sell those products will be around tomorrow.

But MF Global provides two lessons. The first is that US financial institutions are not impervious to euro shocks. The second is that when those problems reach America's shores, they usually ride in on a wave of derivatives. 'The problems that we've had since the inception of the credit derivatives market have never been solved in any meaningful way,' said Janet Tavakoli, president of Tavakoli Structured Finance and an authority on these instruments. 'How many times do we want to live through this?'

MF Global's debacle was a result of complex swaps deals that it had struck with trading partners. While those partners owned the underlying assets - in this case, government debt - MF Global held the risk relating to both market price and default.

These arrangements at MF Global underscore two big problems in the credit derivatives market: risks that can be hidden from view, and risks that are not backed by adequate postings of collateral. These are the same market flaws that helped hide the problems at American International Group (AIG) - problems that arose from insurance that AIG had foolishly written on crummy mortgage securities.

The International Swaps & Derivatives Association (ISDA), an industry lobbying group, contends that the market in credit default swaps is far more transparent than it was in 2008. For example, the Depository Trust and Clearing Corp compiles figures on the number and dollar amount of swaps outstanding on its trade information warehouse.

The numbers are pretty mind-boggling. As at Oct 28, for example, the warehouse reported US$24 billion in net credit default swaps outstanding on debt issued by France, up from US$14.4 billion one year ago. Some US$17 billion in net credit default swaps were outstanding on Spain, up from US$15.5 billion in 2010. Net swaps on Italy were US$21.2 billion at last count, down from US$28.5 billion last year.

The amount of net credit default swap exposure on the imperilled nation of Greece was much smaller: US$3.7 billion late last month. It was US$7 billion a year earlier. Officials at the ISDA say that these bets are manageable because they are probably backed by substantial collateral. Moreover, because of the 'voluntary' nature of the Greek restructuring deal, which would require private holders of the nation's debt to write off half its value, the association predicts that the arrangement should not qualify as a default.

Therefore, the insurance that has been written on all this Greek debt will not cover investor losses generated by the 50 per cent writedown - a disturbing consequence to those who thought that they were buying insurance against that very risk. Given this turn of events, it is hard to imagine why anyone would continue to buy credit default swaps.

In any case, the figures compiled by the Depository Trust and Clearing Corp (DTC) do not show the entire amount of credit insurance that has been written on Greece and other nations. DTC says that it believes that its figures capture 98 per cent of the market, but credit default swaps are often struck privately; not all of them are reported to regulators.

Credit-linked notes

Consider an investment vehicle known as a credit-linked note. In these deals, investors buy a note issued by a special-purpose vehicle that contains a credit default swap referencing a debt issuer, like a government. That swap provides credit insurance to the party buying the protection, meaning that the holder of the note is responsible for losses in a 'credit event', like a default.

Credit-linked notes are very popular, and have been issued extensively by European banks. Many are governed by ISDA contracts, which define the terms of a credit event and require a ruling by the association on whether such an event has occurred.

But some deals have different definitions or contractual language overriding the ISDA agreement. 'The people writing these contracts may say, 'I would like to be paid if there is a voluntary restructuring of debt, or if Greece goes back to the drachma, or if Greece goes to war with Cyprus',' Ms Tavakoli said. 'I can declare a credit event where I am entitled to get paid if any of those events happen.'

Cash calls can also be generated by declines in the market price of the notes or increases in the cost of insuring the underlying sovereign debt issue, according to credit- linked note prospectuses.

The other party has to agree to these terms up front. But given the nature of these bespoke deals, we do not know the full extent of the insurance that investors have written on troubled nations or the circumstances under which the insurance must be paid. Neither do we know who may be facing severe collateral calls or demands for termination payments on the contracts.

When those collateral calls start coming, market values assigned to the securities that have been provided as backup can decline significantly. And when a company's credit rating is downgraded, as MF Global's was in late October, cash demands from skittish trading partners become even greater\. \-- NYT

MF Global's debacle was a result of complex swaps deals that it struck with trading partners ... The arrangements at MF Global underscore two big problems in the credit derivatives market: risks that can be hidden, and risks that are not backed by adequate postings of collateral.
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