CDS demonization watch, ISDA vs Morgenson edition

By Felix Salmon
November 8, 2011
media.comment blog -- corporate blogging done right, with attitude.

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I’m very much enjoying ISDA’s media.comment blog — corporate blogging done right, with attitude. Its latest broadside is directed against Gretchen Morgenson, who spent the first half of her column this weekend railing against the dangerous nature of MF Global’s “bad derivative bets” and “complex swaps deals”.

Now MF Global was a broker-dealer: of course it had a derivatives book and entered into swaps deals once in a while. But Morgenson is talking here about the European sovereign debt deals which ended up sinking the firm — and those deals didn’t have anything to do with derivatives. Here’s ISDA:

MF’s European sovereign debt holdings were just that, bond positions financed via repo transactions. Repos, of course, are NOT OTC derivatives. (They’re also not listed derivatives.) They are basic tools of corporate finance commonly used to finance cash bond positions.

We would have thought that, with a little checking, this point would be pretty obvious to one and all.

Obviously, ISDA wins this particular argument: it’s right, and the NYT is wrong. But don’t hold your breath waiting for a correction: Morgenson is one of those reporters who sees CDS beneath every rock, and even blamed CDS for Greece’s fiscal problems — twice. Neither of those columns received a correction.

In the Greece case, Morgenson saw CDS when she was actually looking at currency swaps, which are at least derivatives. In the MF Global case, she’s seeing CDS when she was actually looking at bog-standard repos, which aren’t derivatives at all.

But here’s the thing: the really annoying part of this episode is not that Morgenson is wrong. It’s that with a little bit of honesty and a little less derivaphobia, she might actually be on to something.

Here’s Morgenson:

MF Global’s debacle was a result of complex swaps deals 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.

And here’s ISDA:

Because MF Global was an SEC registered Broker-Dealer and CFTC registered Futures Commission Merchant, regulators at all times had full transparency into the nature and extent of MF Global’s trading and risk positions.

In short, there were no derivatives, no opaque financial instruments and no hidden risks in the story of MF Global’s downfall.

If you simply delete the terms “complex swaps” and “credit derivatives” from Morgenson’s column, here, she’s actually right, while ISDA’s statement is a little misleading. This is the tragedy of Morgenson: because she’s incapable of getting her facts straight, she needlessly destroys arguments which are fundamentally sound.

MF Global did indeed hide its European sovereign risk from view — it was held off balance sheet, for no good reason. ISDA is, narrowly, right when it says that regulators knew exactly what MF Global was doing — but investors certainly didn’t. And so, contra ISDA, it’s entirely reasonable to consider MF Global’s European bond position to be a “hidden risk in the story of MF Global’s downfall”.

The real problem at MF Global wasn’t CDS, of course, or even derivatives — as ISDA points out, those were non-issues. Instead, it was simply leverage. It’s possible to get overlevered using CDS — just look at AIG. On the other hand, it’s equally possible to get overlevered the old-fashioned way, using nothing but simple repos. And that’s what MF Global did.

Regulators are on this, pretty much. They’re forcing banks to bring their off-balance-sheet deals back onto their balance sheets. And if you’re covered by the Basel agreements, you’re going to be limited as to how much leverage you can take. MF Global had too much: when it became a risk-taking investment bank, rather than just a broker, it should have had its leverage curtailed much more than happened in reality. So there was definitely a regulatory failure here.

But the fact is that MF Global was small enough to fail, and it’s not regulators’ job to prevent people like Jon Corzine from gambling away billions of other people’s dollars. If he couldn’t do that at a bank, he’d probably just do it at a hedge fund instead.

There will always be risk in the markets — without risk, markets are nothing. It’s good to regulate that risk, so that it doesn’t get out of hand, in whatever form it takes. But let’s not kid ourselves that the risk is always in the form of credit default swaps. CDS didn’t bring down Bear Stearns, or Lehman Brothers, or Washington Mutual, or Wachovia, or for that matter any of the Icelandic banks, or RBS, or Fortis, or now Dexia. Or MF Global. Which is why it’s important to concentrate on the things which do cause systemic risk, rather than simply blaming CDS all the time.

Update: Matt Levine has an interesting response, where he does that thing that derivatives wonks do, which is see everything in terms of derivatives. This is an interesting exercise! And it can be applied to, pretty much, anything at all — not just repos, but also stocks, bonds, mortgages, houses, ETFs, you name it.

Matt’s point in this case is that the repo-to-maturity wasn’t simply a repo to maturity: it was a repo to maturity if the bonds matured on time, but it was a repo to the default date if they defaulted before maturity. And so there’s language in the repo contract which references various actions which have to be taken in the event of a default. And so therefore you can consider the repo contract a kind of default derivative, just like a CDS.

On the other hand, every single contract in financial markets has some kind of “if A then B” language in it. And although derivatives types like Matt love to think about that language in terms of derivatives, you need to be very comfortable and sophisticated when it comes to thinking about derivatives in order for that kind of analogy to be helpful. And as Matt would surely agree, Morgenson isn’t. For that matter, her readers aren’t, either. So while such material can be interesting on wonky blogs, it really has no place in the NYT.

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