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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Has money actually been “gambled away?” I thought these leveraged positions hadn’t gone south yet.

Posted by FCBonanno | Report as abusive

This is one of your better posts. I think.

Posted by jmh530 | Report as abusive

ditto jmh530 – good post, Felix

Posted by KidDynamite | Report as abusive

Here’s my take at Streetwise Professor:

Posted by CraigPirrong | Report as abusive

Terrific post Felix.

Posted by khuston1 | Report as abusive

Actually, there were (are) derivatives involved in MF Global’s repos-to-maturity of euro sovereign debt. MF Global stated as much itself, eg in its 10-Q filed on August 3 of this year:

“The Company also enters into certain resale and repurchase transactions that mature on the same date as the underlying collateral (“reverse repo-tomaturity” and “repo-to-maturity” transactions, respectively). These transactions are accounted for as sales and purchases and accordingly the Company derecognizes the related assets and liabilities from the consolidated balance sheets, recognizes a gain or loss on the sale/purchase of the collateral assets, and records a forward repurchase or forward resale commitment at fair value, in accordance with the accounting standard for transfers and servicing. For these specific repurchase transactions that are accounted for as sales and are de-recognized from the consolidated balance sheets, the Company maintains the exposure to the risk of default of the issuer of the underlying collateral assets, such as U.S. government securities or European sovereign debt. The forward repurchase commitment represents the fair value of this exposure and is accounted for as a DERIVATIVE. The value of the derivative is subject to mark to market movements which may cause volatility in the Company’s financial results until maturity of the underlying collateral at which point these instruments will be redeemed at par.” (the capitalisation is mine).

All this doesn’t support Morgenstern, but it may tie with Matt Levine’s point (I can’t check: the link doesn’t work).

(For the 10-Q, go to  /phoenix.zhtml?c=194911&p=irol-sec&secc at01enhanced.1_rs=51&seccat01enhanced.1_ rc=10#7700473 .)

Posted by Kamekon | Report as abusive

Matt Levine is right is to think in terms of derivatives (assuming that “everything is a spread/swap/derivative” is quite useful) but his example is weak: repo to maturity is not a replication of a CDS, it is straight long position in bonds with credit risk and interest rate risk, while a CDS is only about credit risk. To convert a repo to maturity into a CDS, a derivative (interest rate swap) needs to be added.

Posted by alea | Report as abusive


Let’s go over this one more. Just so’s I’m clear.

Matt did NOT talk about “various actions” that might have to be taken in the event of a default. I know. I re-read him.

What he said was it is absurd for ISDA to be criticizing Gretchen Morgenson (and the NYT) for writing MF Global fell victim to “complex swaps” for which MFG bore the “risk relating to both market price and default.”

Apparently this makes her (and presumably at least some other(s) at the NYT) a fool. For in fact she should have known that MF Global was actually brought down by “basic tools of corporate finance” rather than CDS.

(Interestingly, MF Global successfully lobbied the CFTC to continue to use your (customer) money to finance its attempts to profit from trades on these “basic tools” though this isn’t really mentioned).

What Matt said was these repos disaggregated the credit risk and resulted in a collateral call. Just like a CDS would have.

And those calls blew up MF Global. Most all agree on this point.

Now it turns out Matt’s comparison of features neglected to take into account the rate risk.

And sure, both a CDS and these repos disaggregate the credit risk and require mark to market collateral. And sure that capital call was what blew up MFG. But c’mon, get serious “every single contract in financial markets has some kind of “if A then B” language in it.”

And Matt is the “derivatives wonk” and one “need[s] to be very comfortable and sophisticated when it comes to thinking about derivatives in order for that kind of analogy to be helpful.”


Come again?

Posted by alchem1ste | Report as abusive

“…and those deals didn’t have anything to do with derivatives”

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties. %28finance%29

What do words mean? If that is a correct definition, it is hard for me to see how those deals aren’t derivatives. Indeed, if there aren’t changes in the underlying values, than what is the point of the trading to begin with?

Posted by fresnodan | Report as abusive

Dumping on Gretchen Morgenson is nothing but nasty snark technique here, probably in an effort to snare publicity. And then, Salmon says “she’s actually right.” Yes she is. Derivatives are nothing but contracts. Some contracts are bets, and some types of bets are against social policy, or at least used to be, at common law. MF was nothing but a gambling operation, subject to all the compulsions of the top man to double down. Is it appropriate to call it a “bank” at all? As Morgenson says, the risks are hidden from view. And the system has allowed so called “banks” who supposedly evaluate “debt,” to do nothing of the kind. All they are doing is gambling. The regulators are complicit in this and led by the nose by their best buddies, the regulated. Whose view is they can do anything they want with the world’s money and call it banking.

Posted by missprism | Report as abusive

Dear MissPrism: The fundamental error in your complaint it that it wasn’t the world’s money, it was the money of supposedly sophisticated investors who understood, or should have understood, that MF Global was highly leveraged. It is not the government’s job to protect money managers from stupidity or venality. The real scandal is the mutual fund and pension fund managers who put the money they were supposedly taking care of into this speculation.

Posted by rootless_e | Report as abusive