The New Robber Barons Read online

  The crazy but true strategy so far has been "Don't call bad debt, bad debt" -- at least not openly. The continued attempt to "convert" bad loans to good loans by lending bad debtors more money so they can pay interest on bad loans, makes it temporarily unnecessary for Eurozone Banks and other debt holders to take write-downs.

  Greece provides one example. The current last-ditch attempt by the IMF and Eurozone Banks is to impose on Greece exogenous wage deflation under the guise of "internal devaluation," higher retirement age and pension reforms, reduced spending protocols, and "privatization" of Greek assets by foreigners. Greece is coming under pressure to sell crown jewels like Thessaloniki Water and Sewage and Piraeus Port Authority. Greek citizens may view that as robbery, since it will only provide enough to make interest payments on debt for a short period to help the ECB cover up its problems. This benefits the Eurozone banks that are in denial, but it doesn't help Greece.

  The most egregious mistake is the attempt to impose exogenous reform of Greece's inefficient and often ineffective tax collection system. Similar to Iceland, Greek citizens may object to outside interference, demand a vote, and repudiate Greek debt, especially since there is a widespread perception that crony capitalism enriched irresponsible bankers and connected government officials while saddling disenfranchised Greek citizens with a multi-generation bill. Greeks invented democracy and they may be inspired by a slogan of the American Revolution: "No Taxation without Representation!"

  Greece will have to impose fiscal restraint. The austerity measures forced on Greece from the Eurozone will be more onerous than those Greece will have to impose on itself, if it takes back control of its own currency and devalues it.

  Euro: Super Deutsche Mark with a French Accent

  The immediate crisis is in Greece, but it is not alone. It is futile to blame the citizens of deadbeat borrower countries, and given the flaws in the European Union, it isn't entirely their fault. The Euro is a super Deutsche Mark with a French accent. There was no Renaissance of manufacturing and productive jobs in the outer reaches of the Eurozone.

  When you're overleveraged, your entire future depends on cash flow, and the cash flow isn't there for countries like Greece. The ECB is threatening to cut Greece off from bank liquidity -- triggering Greek bank failures -- if there is any restructuring of Greek debt. But the cash flow isn't there to service and repay existing debt, and even selling off assets won't change the long-term situation for Greece.

  The ECB alone bought €75 billion in government bonds, and €45 billion or around 60% of them are Greek debt. Despite JPMorgan's estimate of around €81 billion in capital and reserves for other European banks to sustain a 50% haircut in various government bonds, it likely isn't enough given that government bonds aren't the only challenges the banks face.

  The ECB's problem and the problem for many Eurozone banks is that they do not want to mark their bonds to market. They don't want to know what the debt is really worth, and it's not worth anything near what they're telling themselves it is worth. Threatening Greece so that they can cover up the problem is only a temporary fix, and it isn't fooling anyone.

  Deep Discounts: If PIIGS Owe You Money, You're in Trouble

  Given that no one wants to face the magnitude of the problem, it is difficult to say how bad this can get, but history gives us an example of what needs to be done. In the late 1980's if U.S. banks had marked-to-market their Latin American debt, the losses would have wiped out the capital of Bank of America and Manufacturers Hanover (now part of JPMorgan Chase). Citibank was close to being wiped out. Other banks were also on the ropes: Irving Trust (now part of Bank of New York Mellon), First Chicago (now part of JPMorgan Chase), and Continental (later seized by the FDIC due to other bad loans).

  By the end of 1987, Latin American debt ranged from around 15 cents on the dollar for Bolivian debt to around 35 cents on the dollar for Argentine debt. Market value estimates at the time recognized a valid appraisal method based on the fact that the U.S. had forgiven a large chunk of Mexico's debt and restructured it.

  After Latin American countries defaulted on debts, the subsequent granular restructuring negotiations resulted in various dollar-denominated Brady Bonds, named for then U.S. Treasury Secretary Nicholas Brady. Each country negotiated its own terms. In the earlier Mexican debt restructuring for example, half of the $20 billion debt was forgiven, and the principal of the other half of the debt was secured with a zero coupon UST bond then trading at around $2 billion of the $10 billion face value (the other half of the original debt). Mexico then had to meet the interest payments to service the $10 billion bond.

  Greece is a sovereign country. The ECB is acting as if it can dictate terms to Greece, but as U.S. banks found out, when someone owes you a lot of money and they cannot pay it back, you are in as much trouble -- and sometimes in more trouble -- as they are.

  Endgame for the Euro

  The crisis the Eurozone now faces is that citizens of countries with the most fiscally irresponsible governments and banks may be of a mind to vote out their current governments and repudiate their debt. If the ECB keeps storming out of meetings and isn't willing to engage in meaningful negotiations, then it will be in Greece's best interest to exit the Euro. The ECB can threaten all it likes, but it is dealing with sovereign states.

  Greece can exit the Euro, implement its own austerity programs, force a renegotiation of its debt, and devalue its own currency. If politicians dig in their heels at the expense of Greek citizens, the Euro will likely end not with a whimper, but with a bang, and other distressed debtor countries may follow suit.

  “Standard” Credit Default Swaps on Greece Are a Sham and It’s

  Not a Surprise

  October 27, 2011

  At least it's not a surprise to any financial professional that has paid attention to the false reassurances that the International Swaps and Derivatives Association, Inc. (ISDA) has given over the years to naïve participants in the credit derivatives market.

  "Customers" that accepted ISDA documentation when buying credit default protection on Greece are now discovering that ISDA defends the position that a 50% discount on Greek debt is "voluntary" and therefore not a credit event for credit default swap payment purposes according to its documents. This makes the ISDA "standard" credit default swap (CDS) ineffective as a hedge for the widened spreads (reduced price) of Greek debt, and it makes it ineffective as a protection against default using reasonable standards of impairment to define default. ISDA can defend ambiguous definitions so that payment on the credit default swap is virtually impossible.

  First Step in a CDS: Protect Yourself from the ISDA Cartel

  As previous sovereign problems have illustrated, the only way to buy protection is to rewrite the flawed ISDA "standard" document and agree to new more sensible terms, before concluding the initial trade. One has to first protect oneself from the ISDA cartel "standard" documentation before one can buy sovereign default protection, or any other protection for that matter.

  I explained the need to rewrite ISDA documentation in some detail to the IMF in April 2005. (A short excerpt is on my web site accessible via this link.) In the intervening years ISDA documentation changed, but the need to rewrite it remained the same. I cannot stress enough that the International Swaps and Derivatives Association, Inc. (ISDA) "standard" documentation touted by that organization does a grave disservice to unwary credit default protection buyers. The first thing a credit derivatives trader needs to do when presented with such a document is to rewrite it and agree upon new terms before the trade. There is no such thing as "standard" documentation in the credit derivatives market, particularly the sovereign credit derivatives market.

  Credit default swap documentation has a long history of problems. This isn't the first time investors have been burned in the sovereign credit default swap market. Hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an

  Argentina default a
nd sued when J.P. Morgan refused to pay off on Argentina credit protection contracts they had purchased.

  At issue was the definition of restructuring. Did Argentina's "voluntary debt exchange" in November of 2001 meet the definition of a restructuring? The Republic of Argentina gave bondholders the option to turn in their bonds in exchange for secured loans backed by certain Argentine federal tax revenues. J.P. Morgan claimed this didn't meet the definition of restructuring, at least for the protection it sold to Eternity.

  J.P. Morgan's story was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed its slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.

  In other words, J.P. Morgan made sure its contract language would allow it to get paid when it bought protection and would make it harder for its counterparty to get paid when it sold protection.

  Language Arbitrage: You're Not a Sucker, You're a Customer

  Banks that play this game call it "language arbitrage." Anyone that bought sovereign credit protection on Greece after accepting ISDA "standard" documentation without modifying the language now finds that they are on the wrong side of an "arbitrage." An arbitrage is a riskless money pump. In this case, it means that money has been pumped out of credit default protection buyers with no risk to their counterparties, the financial institutions that ostensibly sold them credit default protection on Greece.

  CHAPTER 14

  MF Global Implodes:

  Ongoing Global Crisis

  Credit Derivatives and Leverage Sank MF Global

  November 4, 2011

  MF Global imploded this week due to proprietary "repo-to-maturity" transactions that are in substance total return swaps, a type of credit derivative. MF Global failed to meet margin calls on credit derivatives linked to risky fixed income debt. Regulators haven't learned much from American International Group's (AIG) and Long Term Capital Management's (LTCM) debacles. Like the "repo-to-maturity" transaction, a total return swap is an off balance sheet transaction treated as a sale, but the total return receiver, MF Global, is long both the price and credit default risk of the reference assets. The total return payer, not MF Global, is technically the legal owner of the reference assets. The attraction of this arrangement is financing and leverage. Naturally, ratings downgrades will trigger increased margin calls. This is all business as (un)usual.

  MF Global Admitted "Diverting" Money from Segregated Accounts

  What isn't usual is diverting money from segregated customer accounts. It's too late to blame "sloppiness, bookkeeping, or accounting," MF Global admitted it "diverted" money from customers' segregated accounts.

  The fact that MF Global was exposed to default risk and liquidity risk because of its "repo-to-maturity" transactions and that the risk was linked to European sovereign debt was disclosed in MF Global's 10K for the year ending March 31, 2011, a required financial statement filed with the SEC. The CFTC and other regulators had the information right under their noses, but it appears they didn't understand that they were looking at a leveraged credit derivative transaction that could lead to margin calls that MF Global would be unable to meet.

  Even if all the money can eventually be recovered, it doesn't change the fact the MF Global took impermissible steps.

  Liar's Poker

  Here's a crazy but true side note. Michael Stockman, the chief risk officer of MF Global (as of January 2011), was in our Liar's Poker training class lampooned by another classmate, Michael Lewis.

  More Liar's Poker

  Last week when customers asked for excess cash from their accounts, MF Global stalled. According to a commodity fund manager I spoke with, MF Global's first stall tactic was to claim it lost wire transfer instructions. Then instead of sending an overnight check, it sent the money snail mail, including checks for hundreds of thousands of dollars. The checks bounced. After the checks bounced, the amounts were still debited from customer accounts and no one at MF Global could or would reverse the check entries. The manager has had to intervene to get MF Global to correct this.

  Rogue Trader and Questionable Risk Management

  Gary Gensler, Jon Corzine's former Goldman Sachs colleague and current head of the Commodities Futures Trading Commission (CFTC), had reason to be concerned about MF Global's risk management. In early 2008, a rogue trader racked up $141.5 million in losses in unauthorized trades that exceeded his trading limits. It seems he accomplished this in under seven hours. In August of this year, MF Global and the underwriters of its 2007 initial public stock offering (IPO) paid around $90 million to settle claims by investors that they were misled about MF Global's risk management prior to the rogue trader's actions. Since 2008, MF Global's financial condition has been nothing to brag about.

  CFTC's Unprecedented Failure to Move Customers' Assets Before FCM's Bankruptcy

  The exchange-traded futures markets have been shaken to the core. The Bankruptcy Code apparently conflicts with the Commodity Exchange Act, so customers of MF Global have less protection than they otherwise might have had. In the past, the exchanges and CFTC "always" moved customer positions before a Futures Commission Merchant (FCM) declared bankruptcy. The CFTC had ample reason to have contingency plans for MF Global based on publicly available information. Yet the Gensler-led CFTC hasn't followed this historical precedent when an FCM led by his former Goldman colleague teetered on the edge of bankruptcy.

  Afternote: The "repo-to-maturity" transaction which was treated as a sale is indeed in substance a total return swap, contrary to what damage control spin-doctors may say. The "repo-to-maturity" label is simply a wolf in sheep's clothing. Total return swaps (and the transactions labeled "repo-to-maturity") are also a credit derivative. MF Global itself disclosed the fact it sought sale treatment for this "repo" transaction while retaining the price and default risk. Regulators seemed at a loss as to how to interpret the substance versus the form. For more on credit derivatives and total return swaps, see also either the first or second editions of my book (Wiley 1998, 2001): Credit Derivatives & Synthetic Structures: A Guide to Instruments and Applications.

  MF Global Revelations Keep Getting Worse

  November 21, 2011

  • Shortfall estimated at $1.2 billion or more (up from $600 million)

  • "Repo-to-Maturity" is a "Total Return Swap-to-Maturity," a Type of Credit Derivative

  • Probable Shortfalls Throughout 2011

  • Regulators Waive Required Tests for Jon Corzine

  • Questions About How MF Global Became a Primary Dealer

  • MF Global Wrote Rubber Checks for some Electronic Checks for Others

  • Tip-Offs for Some Customers?

  • CFTC's Gary Gensler Didn't Act

  • MF Global Debacle Damages a Key Global Market

  When MF Global collapsed on October 31, it was the biggest financial firm to collapse since Lehman in September 2008. Then Chairman and CEO Jon Corzine is connected to the head of one of his key regulators, the Commodity Futures Trading Commission (CFTC), through his former protégé at Goldman Sachs, Gary Gensler. He also knows the Fed's William Dudley, a key member of the Fed's Open Market Committee, from their days at Goldman Sachs. The Fed approved MF Global's status as a primary dealer, a participant in the Fed's Open Market Operations, less than one year after Jon Corzine took its helm and beached it on a reef called leveraged credit risk. [Note: This sentence was corrected on 11/28 to reflect that Jon Corzine was made head of MF Global on March 2010, before (not after) MF Global was awarded primary dealer status.]

  MF Global's officers admitted to federal regulators that before the collapse, the firm diverted cash from customers' accounts that were supposed to be segregated:

  MF Global Holdings LTD. "violated requirements that it keep clients' collateral separate from its own accounts...Craig Donohue, CME Group's chief executive officer, said on a conference call with analysts t
oday that MF Global isn't in compliance with the rules of the exchange and the Commodity Futures Trading Commission." "MF Global Probe May Involve Hundreds of Millions in Funds," Bloomberg News - November 1, 2001 by Silia Brush and Matthew Leising

  Cash in customers' accounts may be invested in allowable transactions, and MF was allowed to make extra revenue from the income. But what isn't allowed, and what MF Global apparently admitted to doing, is to commingle customers' money with its own and take money from customers' accounts to meet margin calls on MF Global's own allowable transactions. Even if all of the money is eventually clawed back and recovered, this remains an impermissible act. Moreover, full recovery -- even if it is possible -- is not the same as restitution. People have been denied access to their money, and businesses and reputations have been tarnished.

  In layman's terms, you may buy a Rolls Royce with customers' excess cash, sell it at a profit, and pocket part of the profits. You may buy a Rolls Royce and try to resell it at a profit with your firm's cash. But you aren't allowed to take customers' money to make the car payments on your firm's Rolls Royce. If one engages in this impermissible activity, it becomes almost impossible to cover up if you have an accident driving your Rolls Royce.