MF Global’s Failure Symptomatic of Larger Risks

The trading firm’s failure reflected Lehman-like liquidity problems, and MF Global isn’t the only example of a financial institution reliant on European sovereign debt.


In the wake of MF Global’s collapse, banks are having an increasingly difficult time raising funds from skeptical investors. The collapse of the trading firm has compelled investors to look ever more closely at the balance sheets of other financial institutions. They are particularly wary of banks that they think might be using too much European sovereign debt as collateral for their short-term borrowing. And they are particularly concerned about institutions that have a very high percentage of short-term debt on their balance sheets — a problem that played a big role in the collapse of MF Global and of Lehman Brothers. The fear is that MF Global’s bankruptcy may turn out to be the beginning of a larger, potentially systemic problem arising from banks’ dependence on such securities.

The trading firm filed for bankruptcy on October 31, overwhelmed by the need to post more margin on European sovereign debt that was used as collateral for a balance sheet that was heavily reliant on short-term funding. MF Global had exposure to $6.3 billion in European sovereign debt, a big part of its $41 billion balance sheet. It kept about 15 percent of that debt hidden through the use of repo transactions that made it appear that it had sold debt. In fact, it was selling the debt and buying it back in an ongoing cycle, one similar to the controversial transactions at the heart of the Lehman collapse.

“People are calling into question the Holy Grail of bank balance sheets, and that is government bonds. For the last 50 years, people felt they haven’t had to worry about a default by a major industrialized country. Now, that mindset is being turned upside down,” says Larry McDonald, senior director of corporate credit sales at Newedge, the brokerage formed by Societe General and Credit Agricole.

In some instances, investment banks trust their customers more than one another, McDonald said. In Europe, banks are depositing cash with the ECB, even though they could get higher rates by lending to one another. The euro Interbank offered rate, which banks pay to borrow from one another on an overnight basis, rose on Wednesday for the first time since October 28, even as European banks took 230 billion euros last week from central banks. That exceeded the 190 billion euros that was expected, according to a poll by Reuters.

The London interbank offered rate, another key rate, has increased on 78 of the last 80 trading days, according to the British Bankers Association, a sign that banks are worried about liquidity and are holding onto cash.

McDonald says some of the issues facing banks in Europe — and, to some extent, the U.S. — are similar to problems that brought down Lehman Brothers, where he worked as a bond trader. “The problems at MF Global were related to a high level of short term funding on the balance sheet, just as they were at Lehman,” says McDonald, who chronicled Lehman’s collapse in A Colossal Failure of Common Sense.


And now, investors are increasingly concerned about Jefferies, the U.S. based investment bank. Barclays, in a recent research note, said there are issues with the percentage of short-term funding on the Jefferies balance sheet.

The spread of Jefferies 5.125 bond due in 2018 rose to 714 basis points over the London interbank offered rate on Tuesday. The price of the bond fell to 82.5, down from 97 in October. The spread was far higher than the comparable spread for other banks such as Morgan Stanley (about 450 basis points). The spread for JPMorgan Chase, which benefits from a massive balance sheet funded by deposits, was about 150 basis points.

In Europe, banks are having trouble raising funds. Unicredit needs to raise capital to improve its balance sheet, but it is having a tough time getting the deal done and has had to offer higher fees to bankers to offset their risk.

The concern about the banks reflects their exposure to European sovereign debt. In Europe, sovereign debt isn’t considered a risk-weighted asset, and regulators have allowed banks to hold massive amounts of it. Now the quality of that debt is being called into question.

A similar concern is unsettling U.S. bank investors, albeit to a lesser degree. Big investment banks in the U.S., such as Morgan Stanley and Goldman Sachs, have refused to fully detail their exposure to European sovereign debt.

To some investors — including Warren Buffett — the banking problems in Europe looking increasingly similar to the crisis sparked by the 2008 collapse of Lehman. He said signs of run on debt and a run on banks have started in Europe, and that it will take more powerful action by officials in Europe to bring the situation under control.

“When you have a loss of confidence, that begins a run, which has occurred to some degree on both sovereign debt and banks over there. In 2008, we had our own run in the United States, and it took—it took the full power of the United States and some very strong action,” Buffett said on CNBC. “The ability—or the belief that the authorities would do whatever it led us out. But it’s not clear who can say, ‘We’ll do whatever it takes,’ over there and that they’ve got the ability to do whatever it takes. It’s going to have to become much more clear as to—as to who can do what and that they will do it.”

So far, many regulators and elected officials in Europe have preferred to blame investors and traders, rather than financial institutions themselves, for high spreads on banks and sovereign debt. Now investors such as Buffett are prodding them to act--before they have an MF Global-like collapse on their hands.