Okay. I think I have got it. I seem to be smarter, with a better-functioning brain, this morning then I was last night in analyzing what may be the eighth-largest bankruptcy in U.S. history:
We need a three-stage model:
- In stage zero MF Global sets up the financing with its counterparty and buys southern Europe's bonds.
- In stage one we learn whether the market is tolerant or intolerant of southern Europe risk: if the market is tolerant the bond prices stay high; if the market is intolerant the bond prices collapse.
- In stage two southern Europe either pays off its bonds or defaults.
We have four possible outcomes: 1--market risk tolerance and bond payoff; 2--risk intolerance and payoff; 3--risk tolerance and default; and 4--risk intolerance and default.
MF Global wins substantially in Outcome (1), if the market remains risk-tolerant and if southern Europe pays off. They have then made a large leveraged bet on southern Europe and on the market's risk tolerance, and have won.
The counterparty also wins in Outcome (1), the tolerance-payoff scenario. But it does not win as big as it would have won had it simply bought the bonds out right.
In the other three outcomes MF Global is toast.
The counterparty is toast in both of the southern Europe default scenarios--in Outcomes (3) and (4).
In Outcome (2), however, in the intolerant-payoff scenario, the counterparty wins big and wins bigger than MF Global wins in Outcome (1). In Outcome (2) the counterparty gets its bonds paid off, and they acquired the bonds for an initial payment less by the initial collateral margin than they would have had they simply bought the bonds outright themselves in stage 0.
MF Global is thus making two directional bets: the bet that southern Europe will pay off, and the bet that the market will remain tolerant of southern Europe risk in the meantime.
If either of those bets fails, MF Global is toast.
The counterparty is making a more complex bet. Its best scenario is if the market loses its tolerance for southern-Europe risk but southern Europe nevertheless pays off is bonds. It profits if the market remains risk-tolerant and if southern Europe pays off.
MF Global's bet is (i) highly leveraged, and (ii) requires both southern Europe to pay off and the market to remain risk-tolerant. The counterparty is making a lower-leverage bet on southern Europe--giving, and within that bet it is also making a directional bet that in the meantime the market will lose its tolerance for southern-Europe risk.
The counterparty's bet is attractive to somebody who is (1) confident in southern Europe, and (2) patient capital that believes that fluctuations in market risk tolerance do not carry much fundamental information.
MF Global's bet is attractive to… (a) rogue traders (and rogue CEOs) speculating with other people's money, (b) those who are highly confident in their ability to switch from highly-leveraged speculators to patient well-capitalized investors in fundamentals if necessary, and (c) those who don't believe that there are shocks to risk tolerance that are orthogonal to shocks to fundamentals.
Matthew Leising and Donal Griffin:
Corzine’s Lack of MF Global Controls Shown With Missing Cash: MF Global Holdings Ltd.’s bankruptcy, the eighth-largest in U.S. history, is exposing a lack of internal controls that may have prevented a last-minute rescue of Jon Corzine’s futures broker. The day it filed for Chapter 11 protection, New York-based MF Global disclosed a shortfall in customer accounts that people with knowledge of the matter said may be about $700 million. CME Group Inc., which has the authority to audit those accounts, said yesterday it didn’t know how much client money was missing.
Corzine, 64, steered MF Global into bankruptcy proceedings on Oct. 31 after increasing risk-taking at the firm, including investments in European sovereign debt that roiled markets. Discrepancies over the missing funds that were used to back futures trades sent Interactive Brokers Group Inc. fleeing from a potential acquisition that may have averted the filing, according to a board member at the Greenwich, Connecticut, firm. “The board certainly considered that purchase and stepped away from it at a point where it became clear there were lots of uncertainties about the accounts and segregated funds,” Hans Stoll, an Interactive Brokers director and a professor of finance at Vanderbilt University in Nashville, Tennessee, said yesterday in a telephone interview…