Experts have revealed to Euromoney that MF Global used the same methods as Lehman Brothers for disguising the amount of leverage it had, by using the repo markets.
This, in turn, has exposed the systemic risks in the short-term funding markets.
“There is this issue of debt masking out there,” one New York-based banker tells Euromoney. “One way banks can reduce the appearance of leverage is through the repo market. MF Global and Lehman Brothers both engaged in this activity to various degrees by getting the assets off the balance sheet and appearing to have less leverage around quarterly reporting time.”
When it became clear that the $6.3 billion sovereign debt position that brought down MF Global was collateralizing a repo trade, increased scrutiny of the short-term funding market seemed inevitable.
By treating the exposure as repo-to-maturity, the brokerage was able to treat the assets as off-balance sheet, an idiosyncrasy of the market that can be exploited by banks and brokerage houses when reporting quarterly figures.
Previously, Lehman was removing the securities put into the repo market from the asset side of its balance sheet and using the borrowed cash to pay some of its debt temporarily, the now notorious Repo 105 trades.
By engaging such activity towards the end of every fiscal quarter since 2001, Lehman was able to decrease its assets while keeping its equity unchanged. In their recent book Regulating Wall Street: The Dodd-Frank Act and The New Architecture of Global Finance, Viral Acharya, CV Starr Professor of Economics at NYU Stern’s Department of Finance, and his colleagues say that in some quarters, Lehman’s Repo 105 transactions amounted to much as $50 billion.
“The idea of the Dodd-Frank Act was to address the too-big-to-fail problem, at least some of which arises from short-term financing and the shadow banking markets,” says Acharya. “So it is odd that the Dodd-Frank Act leaves out the repo market. It is a concern, as what if Bank of America were to go under from exposure to housing markets and a double-dip recession? With 10% to 20% of overall assets held by the US financial sector being with Bank of America, that would result in the several money market funds that provided short-term financing in exchange for Bank of America's mortgage-backed securities assets all trying to sell into an illiquid market. One of those funds could easily break the buck as a result.
"In addition, the lack of clarity around which money market funds are exposed and to what extent could create a further contagious run on other funds and we could be back to September 2008.”
For the full story, don’t forget to check out the December issue of Euromoney magazine.
