Streetwise Professor

November 4, 2011

MFers Don’t Understand MTM and VM?

Filed under: Derivatives,Economics,Financial Crisis II,Politics,Regulation — The Professor @ 9:49 am

David at Deus ex Machiatto turns his discerning and well-trained eye to the MF mess.  He basically concurs with my initial diagnosis that what brought down MF was increased haircuts on its repo trades.  He concludes:

It seems much more likely to me that Corzine et al. didn’t understand the repo haircut risk – a modern phenomenon – than that they were rogues. Or, to use my own slang, this is a cockup not a conspiracy.

This would indeed be a cockup of massive proportions, and an ironic one to boot.  Adjustment of repo haircuts is analogous to marking-to-market and variation margining in the futures world–which one of the world’s largest futures brokerages deals with on a daily basis.  Did they think that this wasn’t an issue in repo?  The very newness of the phenomenon should have put them on warning.

As David explains in his excellent and very readable book Unravelling the Credit Crunch, mark-to-market gives rise to risks throughout the life of the trade.  Included in these risks are risks to fundamentals–in this case, changes in the likelihood of default on Italian, Portuguese, etc. bonds.  But they also include changes in risk tolerance/risk aversion–the market price of default risk.  They also include liquidity risks: market prices change with liquidity conditions as well as fundamental conditions.  In a mark-to-market mechanism, these risks combine to give rise to funding risk: you have to be able to access liquidity in order to make the cash payments obligations caused by changes in market prices driven by any or all of these factors.

These considerations are second nature–hell, fifth nature–to anyone who trades futures with their rigorous mark-to-market and variation margining mechanism.  That is MF’s bread-and-butter, so it should have been particularly conscious of this issue.  Any trading strategy has to be made, and funding for it provided, based on an assessment and understanding of these risks.  Did Corzine really, truly not understand this was relevant for the repo trades in question?  That would be negligent beyond belief.  At the very least, he should have asked the question:  What are the funding risks over the life of this trade?  You should ask that about any and every trade you make.

In other words, Corzine’s trading strategy was either grossly negligent in its failure to take into account important risks (which seems to be David’s interpretation), or extremely reckless in its disregard thereof.

Cockup would be an understated description if Corzine did not ask this question, and take these risks into account.  Or perhaps he did, but thought they were worth running.  No, not a conspiracy, but an indication of a substantial willingness to take risk and/or a colossal deprecation of those risks.

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  1. However you judge this, and to put this at a level that the MF risk management team would understand, this was a Bozo No-No. since they dipped into customer funds – I hope it is one with jail time attached.

    Comment by Sotos — November 4, 2011 @ 11:16 am

  2. He did not believe in wearing a seatbelt either.

    Comment by Margaret — November 4, 2011 @ 2:29 pm

  3. You nailed it with the last point. The trades were cleared through a CCP so were haircut and marked to market. They understood they risks and modelled downgrade funding etc. Management ignored the risk and punted to try and book a gain at inception and hopefully earn a handsome yield.

    Comment by Greenwichmeantiger — November 4, 2011 @ 2:48 pm

  4. Great set of posts here.

    MF was destroyed by the same things that destroyed MS, GS, LEH, Merrill + Bear: Near-total dependance on overnight funding markets, no capital to speak of, hence insane leverage. Fraud + outright theft may have played a part here, too. When that leverage was used to get long apparently high-yielding junk that was getting marked down daily and intraday, it didn’t take much to blow up the firm, as MS and GS discovered.

    MF — unlike MS + GS — didn’t have Hank Paulson at Treasury and Timmy! Geithner at the NY Fed to get a Sunday-night bank holding-company charter, and all that no-cost funding from Uncle Sugar. None of these folks — or their regulators — understood their risk positions. They still don’t. As a result markets remain in a near-chaotic state, a heartbeat away from seizing up again.

    Comment by markets.aurelius — November 5, 2011 @ 1:47 pm


    Can the good professor explain what the hell the CME is doing, besides constantly hiking (though we don’t hear about them pulling back) the margins on gold to keep the price down and avoid more embarassment for the Bernanke (or alternatively, to create another Chinese/Bundesbank buying window?)

    Comment by Mr. X — November 5, 2011 @ 5:00 pm

  6. And a more fundamental argument:

    I was recently challenged by a contributor to write something positive, and so I decided to write about the single most positive outcome of the current financial crisis in Europe: the complete collapse of the corrupt, predatory, pathological global banking sector and its dealers, the central banks. Exploring why this is so reveals the insurmountable internal conflicts in our current financial system, and also illuminates the systemic political propaganda which is deployed daily to prop up a parasitic, corrupting, pathologically destructive financial system.

    Banksterism is the new Fascism and the Fed is the Reichs Chancellery of today. I suppose that would make Bank of Iternational Settlements in Switzerland the Eagle’s Nest at Berchtesgaden.

    In modern finance, high-risk “investments” (wagers) with high returns can be taken on without worry because any and all risk can be hedged to zero, even in super high-risk wagers.

    And since even high-risk positions can be seamlessly hedged to zero, then there is no reason not to borrow money to increase the size of your wagers: since you can’t lose, then why not? Wagering in risk-free skimming with borrowed or leveraged money is simply rational.

    Put these together and we see how a system based on risk-free skimming eventually leverages itself to the point that the slightest disruption can bring down the entire over-leveraged, over-extended system.

    Why is this so? Every hedge has a counterparty who is supposed to pay off if the initial wager blows up. A system based on risk-free hedging is ultimately a self-organizing system which maximizes return by increasing bet sizes, leveraging/borrowing to near infinity and hedging every hedge as well as every wager.

    This creates long chains of hedges and counterparties.

    I suspect the Russians, who would appear at first glance to have the most to gain of any country from some sort of new soft global gold standard given their huge commodity reserves (as Asia Times has reported, they’ve been quietly forming a kind of uranium OPEC with Kazahkstan and Mongolia), will have a hand in destroying the 4th Reich. Just like they finished off the 3rd with some help from the West.

    Think about it: U.S., Canada, Australia and New Zealand as major ag exporters would do well under such a system (particularly if oil is part of the currency backing ‘basket’ of commodities and dumping the Dems equals opening up the biggest oil shale resource in the lower 48 in Utah/Colorado/Wyoming). So would Russia, Brazil and Argentina. But China’s ability to produce cheap crap with artificially lower pegged fiat would be hurt, and New York and the City of London — along with Washington’s ability to spend vastly more than it takes in — would all be in deep $#@&. Which is why you can see how the battle lines could potentially shape up.

    Comment by Mr. X — November 5, 2011 @ 5:06 pm

  7. […] Update. My thanks are due to the Streetwise Professor for a very kind commentary on this post. […]

    Pingback by Deus Ex Macchiato » Remember collateral support default — November 7, 2011 @ 5:27 am

  8. Well you are only supposed to be using MTM accounting for your positions if you actually could, if necessary, liquidate them in a day. If you can’t do that, owing to lack of liquidity, then in most jurisdictions I’ve heard of, you should be using accrual accounting to value your positions.

    One thing 2008 taught us, or ought to have done, was the limited utility of [email protected] as a risk tool. It was excellent up to a point – if you had a big overnight change in position value, then only 2 things could have happened: the market had moved or your position had moved. In either case, the alert provided you with the solution as well, which was to do a countervailing trade.

    The trouble in 2008 was that there were no such trades available to be done, so for some people it became a ‘so what’ type of answer. Model risk it seems is still with us.

    I know nothing about the causes of MFG’s demise save what I’ve read in the press but it does seem as though somebody tried to call the bottom and buy in there, only to find the bottom was some way off yet.

    Buying Enron at $15, after it had been $90 a few months before, must have seemed smart in much the same way.

    Comment by Green as Grass — November 7, 2011 @ 8:11 am

  9. @Green–MTM in this context doesn’t refer to accounting per se–it refers to whether MF had to post additional collateral in response to declines in the market value of the collateral on its repos, analogous to variation margin.

    I don’t think this was a VaR problem per se . . . more an issue of MF not taking the funding risk into account.

    The ProfessorComment by The Professor — November 7, 2011 @ 6:39 pm

  10. Agreed; all I am saying really is that 2008 ought to have taught us that there is such a thing as ‘model risk’. That is, in assessing the risks of buying a shitload of European debt, you’d think it would be a good idea to think about all the risks that were possible.

    The one we already knew about pre-2008 was the one where, despite your assumptions, you cannot actually dump your whole Greek debt position in a day. This ought to have had you in bloody trouble with your auditors already, long before 2008, but apparently in a number of cases it didn’t.

    Besides that though is the risk that someone decides by fiat that you aren’t owed $1 at all, you’re owed 40 cents. From what I have read it seems that this one hadn’t been provided for, which is a bit gobnsmacking considering that we’ve been talking about bond haircuts for a couple of years now.

    This is what I mean by model risk: your model doesn’t model enough of the right stuff, or can’t.

    As it happens this is also my major critique of climate models too – in predicting the emissions of 2111, they make no attempt to infer what the oil price will be, meaning it could be $$stupid / bbl and hence the whole model is stupid too.

    Comment by Green as Grass — November 8, 2011 @ 5:26 am

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