The drama of MF Global’s demise continues. The story centers around leverage, particularly the use “repo-to-maturity” agreements that allowed MF Global to use customer money to buy more European debt than it could afford.
A repurchase agreement is a contract where one party sells a security (in their case, a European bond) to a counterparty and agrees to repurchase the security at a later date. In essence, the party selling the initial security is receiving money now (effectively borrowing cash) and using the security as collateral. The counterparty is said to be entering into a “reverse repo” and is paying for the security now (effectively lending money), taking delivery of the collateral, and agreeing to return the collateral in exchange for repayment of the cash in the future.
Sounds complicated, but it’s nothing more than a collateralized loan. Many of these loans are overnight where the collateral is returned the next day or a few days later. Repo-to-maturity is a repurchase agreement where the repurchase date is the maturity date of the bonds being used as collateral.
MF Global’s failure is blamed on a $6.3 billion exposure to European bonds. Turns out the exposure was much greater because MF Global was able to use borrowed money from repos to buy the European bonds.
While MF Global disclosed in a May 20 filing that its net holdings among five European countries was $6.3 billion, it also said the figure was “net of hedging transactions.” The firm had actually expanded its bets to $11.5 billion as of June 30, according to data in the SEC filings.
(read the Bloomberg BusinessWeek article here)
· Why would a firm enter a repurchase agreement? Why enter a reverse repurchase agreement?
· According to the Bloomberg article, how did MF Global use repos to try to earn a profit?