Guest Post by Chris Whalen of Institutional Risk Analytics and blogger for Reuters.
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There have been a number of good analyses of the MF Global collapse and the role of “repo-to-maturity” trades in the failure. See “MF Global and Repo Accounting,” which also has links to Felix Salmon and several other good posts. Read Yves Smith’s comment on Lehman Brothers from last March as well.
But one of the things that most people seem to miss in this fiasco is the role of off-balance-sheet or OBS accounting in making the failure of MF Global a reality and, in particular, what it implies for other, larger banks. Many observers say that the FASB erred by not “fixing” the OBS issue via disclosure, but in fact we need to eliminate OBS treatment of all assets, period. Indeed, the MF Global failure suggests that the US and EU banking systems may be facing a far larger problem than even the most bearish analysts suspect.
First let’s ponder a recent report by the International Swap Dealers Association or ISDA. A post on RiskCenter summarizes the findings:
“The counterparty credit risk exposure of 12 US bank holding companies and international banking companies to monoline insurers has led to some $54 billion in write-downs by the banks since 2007, according to a new analysis by the International Swaps and Derivatives Association, Inc. (ISDA). ISDA conducted the study as part of its examination into the losses incurred in the US banking system due to counterparty defaults on OTC derivatives. An earlier paper on the subject, based on data from the US Office of the Comptroller of the Currency (OCC), showed such losses for US banks amounted to only $2.7 billion from 2007 through the first quarter of 2011. After further investigation, it became apparent that the transactions involving subprime mortgage risk taken in synthetic form (via derivatives) were booked in firms outside the US banking system.”
What the ISDA report suggests, oddly enough, is that the large banks which comprise the most important members of the derivatives markets and ISDA both have been under-reporting their losses to monoline insurers by more than 20x in their SEC filings. But the report also confirms in the last sentence the key factoid that should make the blood of Barack Obama, Jamie Dimon and FOMC members run cold, namely that the banks were hiding these losses on RMBS from investors and regulators in OBS vehicles. This is essentially systematic securities fraud, enabled and facilitated by the FASB and ISDA. By relying solely on GAAP accounting, the OCC, Fed and other regulators have left themselves completely in the dark regarding large bank OBS exposures.
So now we come to the MF Global failure and Jon “Superman” Corzine, who followed the familiar pattern of taking a financial and legal template developed in Washington and specifically the Treasury market and extending the model into inferior assets. This is precisely the same behavioral pathology, to my friends Barry Ritholtz and Joe Nocera, which Wall Street used in the subprime crisis. Washington started the game rolling and Wall Street made it better. As Flo and Eddie sang with Frank Zappa and the Mothers at the Fillmore East in June 1971, “so happy together.”
In a “repo to maturity,” banks are permitted to match fund Treasury securities and then lend the securities out. The bonds are not shown on the books of the bank or dealer, because the servile functionaries at the FASB have blessed the repo as a risk-shifting transaction. In economic terms nothing could be further from the truth, but reality has never stopped the FASB from embracing acts of global idiocy like fair value accounting and OBS treatment for RMBS securitizations.
The repo-to-maturity arrangement works with Treasury paper because the Fed stands willing to buy any securities issued by the US government at par, thus the repo has no risk. The problem comes, however, when the financial institution starts to think that it can do these same, repo-to-maturity trades with paper other than Treasury collateral. This is why we need to eliminate the OBS distinction in the US immediately.
What Corzine apparently did at MF Global was to put on repo-to-maturity trades on with non-US, EU government debt. While the post-WWII construct created by the US makes all debt issued by members of the OECD “zero risk” under the Basel accord, this reality is now disintegrating. The sovereigns are now the inferior credits in the global markets, but many large US and EU banks are loaded to the gills with this debt. Unfortunately Corzine did not get the memo. Remember, the OECD is a Cold War construct of the US meant to help defeat the Soviet Union. It has nothing to do with assessing credit risk or even economic capacity to service debt.
So when people ask me about the exposure of US banks to EU governments, the answer is that we do not know because of the FASB and the willingness of US bank regulators to look the other way by accepting GAAP disclosure as sufficient. When JPM, GS and MS tell us that their EU exposure is limited, what they are really saying is that their GAAP disclosed exposures are small. The real risk exposure is, in my view, far larger.
If we could see all of the OBS exposures of the top 10 US banks to EU government via deceptive if for now legal canards such as repo-to-maturity, my sense is that the difference between the reported risk of US banks on EU government debt and the actual risk exposures would be the same as the gap between the OCC’s view of bank risk on monoline insurers and the reality just confirmed by ISDA. Thanks guys.
And just to show we are paying attention, ISDA is wrong to criticize Gretchen Morgenson’s characterization of the MF Global collapse in last Sunday’s New York Times. Cash is cash, but repo-to-maturity is a derivative, just like any trade that involves an ISDA agreement.
So here is the question Morgenson should ask the top bank CEOs: How much exposure to EU government debt does you bank have OBS? I suspect that the reason for the great performance in financials today is that people in the markets have reached the same conclusion. So, to me, we should hit the bid for US large cap financials in the AM regardless of what is happening in the EU tomorrow – or not.