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Understanding Jon Corzine's Big Bet on Europe

I do find it somewhat gratifying what a large proportion of the tie my guesses turn out to be correct. But I really do wish that, if I was going to be right so much of the time, I were more optimistic:

Miles Weiss, Cristina Alesci and Matt Leising, November 29:

Corzine Pushed Europe Bet to $11.5 Billion: Jon Corzine bet $11.5 billion on European sovereign debt in his bid to rebuild profits at MF Global Holdings Ltd., almost twice the net amount disclosed to investors, and relied on short-term hedges that left the firm exposed to larger losses if they couldn’t be rolled over… overcame resistance from directors, senior traders and risk managers to accumulate the bonds…. He repeatedly ratcheted up his wager on the debt of countries including Italy and Spain, booking gains along the way, according to filings. The short-term hedges matured before the bonds, meaning the net amount at risk could increase if investors lost confidence in either European sovereigns or MF Global and new hedges couldn’t be bought.

“If that assumption does not come to pass, their risk mushrooms,” said Matthew Pieniazek, president of Darling Consulting Group, a Newburyport, Massachusetts, firm that advises banks on managing their balance sheets….

On earnings conference calls with investors, Corzine described the debt, which matured at various points in 2012, as a low-risk way to profit from “dislocations” in Europe’s sovereign-debt market…. At multiple meetings, Corzine reassured directors that the trades would work out, said the person, who asked not to be identified…. Corzine said the European countries he selected wouldn’t default before the bonds matured, and that the market was mis-pricing the debt….

The deal began to unravel in August when the Financial Industry Regulatory Authority told MF Global to add capital to its U.S. brokerage to back the trades…. Corzine’s strategy may ultimately have proven “very profitable” had the firm been able to hold the trades to maturity, said Josh Galper, the managing principal at Finadium, a Concord, Massachusetts, investment research and consulting firm. The firm’s collapse stemmed from a cash shortage, with trading partners and lenders seeking more collateral after the credit downgrade, rather than actual losses on the bonds, Galper said. “If MF Global had bought the same trade without leverage, there would have been no issue,” Galper said in an interview.

Me, November 2:

What Went Down at MF Global?: I Think I Am Less a Bear of Little Brain Today Than I Was Yesterday…

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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.

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MF Global wins substantially in Outcome (1), if the market remains risk-tolerance 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. It loses if southern Europe defaults--but it loses less badly than if it had bought southern Europe debt itself.

MF Global's bet is (i) highly leveraged, and (ii) requires both southern Europe to payoff and the market to remain risk-tolerant. The counterparty is making a lower-leverage bet on southern Europe--and within that bet 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.