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Uncontrolled Risk Taking, Not Bad Accounting, Did MF Global In

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Jon Corzine got the chief executive job at MF Global in early 2010 for one reason: Chris Flowers bailed the firm out in 2008 after a wheat trader’s shenanigans cost it $140 million. Flowers was growing impatient with constant losses and Corzine was brought in to return the firm to profitability.

MF Global’s core business was losing money, squeezed by a low interest rate environment and declining trading volumes for futures customers. Corzine could return the firm to profitability by shrinking it, expanding it, or choosing Door No. 3 – betting the firm on risky trades in European sovereign debt.

Trades that required lots of liquidity. And careful risk management.

Rather than a reasoned strategy to turn the firm around, Corzine chose chutzpah. He put a perverse twist on the repurchase trade, routinely used in the past to squeeze some additional income out of the Treasury securities that are traditionally on hand as part of normal business operations. Corzine used the repo trade to finance purchases of billions of dollars of volatile European sovereign debt instead, thereby multiplying the liquidity and risk management needed to come out ahead.

It’s not every day the way a trade is accounted for makes such a difference in how investors, and the market in general, eventually view its success or failure. Buried on page 65 of the 180-page report issued by the trustee on June 4 are new details about MF Global’s fatal high-risk repo-to-maturity trades.

The transactions were accounted for as profitable sales of sovereign European debt. Giddens, the trustee, reveals that the unwinding of the repo-to-maturity transactions between MF Global UK and as yet unnamed counterparties didn’t happen at the maturity date but two days earlier.

Some bloggers like Yves Smith at Naked Capitalism have highlighted this oddity. Was MF Global’s accounting treatment for the trades as sales, and auditor PricewaterhouseCooper’s approval of that treatment, still correct? Floyd Norris of The New York Times weighed in and, in a nutshell, said that, in his expert opinion, the accounting was correct but unfortunately corrupt.

Some continue to compare MF Global’s repo-to-maturity trades to Lehman’s Repo 105 trades, also treated as sales. The accounting standards for both these trades and repo-to-maturity trades allowed off-balance-sheet treatment. Lehman’s objective in using repurchase transactions and treating those trades as asset sales were very different than MF Global’s, however.

The Repo 105 transaction began with an exchange of $105 of collateral for a $100 loan. Because the repo was structured that way, Lehman called it a “sale” and, therefore, did not record the loan on its books. The transaction reduced assets – Lehman used highly liquid, marketable securities for the trades. Lehman realized a benefit by using the cash received to pay down other liabilities for a temporary improvement in the leverage ratio. Lehman “bought” back the security 10 days after the quarter end, paying an additional above-market amount in “interest” for the faux-loan, and took back the full collateral on its books.

The use of excess collateral, securities worth 105% of loan value instead of the typical 102%, signified “control” of the assets had passed from Lehman to the counterparties and, therefore, a “sale” could be recorded. The accounting treatment was approved by auditor Ernst & Young, which is still facing fraud allegations from the New York Attorney General for its alleged complicity. The excess collateral was a necessary condition for treating the transaction as a “sale” but not a sufficient condition for any US law firm to bless it. Lehman went to the U.K. to get a “true sale” legal opinion.

In May of 2011, the Financial Accounting Standards Board amended the standard Lehman had manipulated. The amount of collateral should not be a determining factor of effective control, the board proclaimed.

The MF Global repo-to-maturity trades were intended to juice profitability, not dress up the balance sheet like Lehman Brothers’ infamous Repo 105 transactions. Unlike the opaque Lehman, MF Global fully disclosed the trades and their accounting treatment including the off-balance sheet effect. Treating the trades as sales allowed MF Global to book a profit immediately in its U.S. unit.

PricewaterhouseCoopers approved the accounting treatment. However, for some strange reason the trade expired two days prior to the bonds’ maturity. This was not previously disclosed but has no effect on the accounting treatment according to FASB Topic 860 since the period to maturity was so short MF GlobalU.K. could not sell the securities before maturity.

From Transfers and Servicing (Topic 860), Reconsideration of Effective Control for Repurchase Agreements, No. 2011-03 April 2011:

A transferor’s agreement to repurchase a transferred financial asset would not be considered a repurchase or redemption before maturity if, because of the timing of the redemption, the transferor would be unable to sell the financial asset again before its maturity (that is, the period until maturity is so short that the typical settlement is a net cash payment). 

Giddens, the SIPA trustee, believes LCH.Clearnet, the intermediary between MF Global and the ultimate but as yet unknown counterparties to the trades, set the expiration date short to avoid the risk of default by sovereigns. But there is no evidence that the bonds would have a higher risk of default as they got closer to the maturity date. In fact, the opposite is typically true. MF Global UK funded the unwinding of the positions two days before the bonds matured and paid off. MF Global UK — not LCH — bore the risk of issuer default, which was minuscule, during that that two-day period. MF Global UK, in turn, expected MF Global US to fund that last leg of the trade.

I think the trades were structured two days short of maturity at the insistence of the clearinghouse, LCH.Clearnet. Sources tell me counterparties were more worried at this point about MF Global defaulting on margin calls than European countries defaulting on the bonds. MF Global CFO Henri Steenkamp warned Corzine, according to the trustee's report, that counterparties might bail on the firm if a ratings downgrade occurred.

“…there could be an impact on the reverse RTM netting trades as these are to different maturities than the original RTM’s…some counterparties will choose not to roll over transactions or the trading counterpart can’t trade with us due to our rating. If this were to happen, then MFG Inc could lose its netting benefit on these reverses and thus be subject to higher margins, thereby increasing liquidity needs...”

More important than the debate over the accounting treatment, which appears moot, is the fact that the trustee's report, for all its depth and breadth and fingers pointed at executives with threats of litigation, still does not tell us who, specifically, was on the receiving end of the $1.6 billion of stolen customer funds. The trustee admits he may not have all the facts.

“This Report reflects the Trustee’s best judgment based on information currently available to the Trustee, which is less than the amount of information available to law enforcement and regulators…”

What is known is that Henri Steenkamp, CFO, appears, based on the trustee’s report, to have been much more involved in managing the “shell game” that developed to fund Corzine’s trades than he admitted to Congress. What is also known is Steenkamp, an accountant’s accountant who likely worked with Corzine to design a structure that met all the requirements for accounting rules, is an alumni of PwC, MF Global’s auditor.

Giddens, the trustee, doesn’t tell us whether PwC, the shareholders’ watchdog, ever barked.