Those who think back to November 2011 will recall that it wasn’t Jon Corzine’s wrong way bet on Italian bonds that ultimately led to the bankruptcy of MF Global, well it did in part, but the real Chapter 11 cause was the sudden liquidity shortage due to the way the trades were structured as a Repo To Maturity, where the bank had hoped to collect the carry from the bond coupons, thereby offsetting the nominal repo cost of funding. The kind of deal which is the very definition of collecting pennies in front of a steamroller, as while the funding cost may be tiny and the capital allocated negligible (due to the nearly infinite implied leverage involved when using repo), when the underlying instrument crashes, and the originating counterparty has to fund a massive variation margin shortfall, that is when the shadow transformation cascade triggers an immediate liquidity crisis, which can result in liquidation cascade in a few brief hours. It happened with MF Global, it happened with Lehman too.
And, we now learn, it also happened with Italy’s most troubled and oldest bank, Monte Paschi (BMPS), whose endless bailouts, political intrigue, depoit runs, and cooked books have all been covered extensively here previously.
Only unlike MF Global and Lehman, the Italian government came to the rescue of BMPS for one simple reason: a failure of one bank would have set off a chain of depositor-running dominoes that would have destroyed the Italian banking system, and likely led to a Europe-wide panic, leading to the collapse of the Eurozone.
As it turns out, it was precisely a repo (term repo to be precisely) that is what led to the most recent Monte Paschi bailout. Reuters reports:
Monte dei Paschi had to put up more than 2.8 billion euros ($3.65 billion) by way of collateral for two loss-making derivatives trades at the center of an investigation of alleged fraud at Italy’s third-biggest lender.
The Tuscan bank said in a statement on Wednesday that it had provided collateral of 1.871 billion euros at the end of March for the derivative deal known as “Alexandria” with Japanese bank Nomura.
The bank also said it had put up a collateral of 939.1 million euros linked to the “Santorini” deal signed in 2008 with Deutsche Bank.
In other words virtually the entire (most recent) $4 billion Italian bailout of Monte Paschi was merely to satisfy the bank’s margin calls with Nomura and Deutsche Bank. Net result: taxpayers end up funding obligations that BMPS had made long ago, yet which cash immediately left Italy and was promptly wired to offshore accounts of the German and Japanese banks. Yes, it may come back one day when the variation margin swings back the other way, but most likely it won’t.
So what exactly did Monte Paschi purchase using the repo funding? Why the very same instrument that took down MF Global – Italian bonds.
Under the risky deals at the heart of the probe, Monte dei Paschi funded its investment in long-term Italian government bonds through long-term repurchase agreements with Nomura and Deutsche Bank.
In a repurchase, or repo, agreement, a company uses assets as collateral to raise funds and pledges to buy the assets back for a pre-agreed price at a later date.
But as the value of the bonds guaranteeing the loans fell because of the euro zone crisis, the bets backfired and Monte dei Paschi was forced to put up more collateral with both banks.
What is, however, hilarious, and what proves just how clueless almost everyone is about the true nature of the virtually unlimited in their leverage transactions (and needing zero initial capital, and in the case of government bonds – zero initial margin as well) taking place in the shadow economy such as repo, is that Siena prosecutors were so confused about who owned the underlying assets, they ordered the seizure of €1.95 billion in assets from Nomura, which were in fact assets belonging to the Japanese bank in lieu of the unsatisfied variation margin.
In other words, the Italian prosecutors nearly confiscated assets belonging to another bank just to distract from the epic financial crimes going on at the very much insolvent bank founded and operating in their city. Of course, in retrospect they were merely completely clueless and did whatever Monte Paschi’ lawyers told them to do. After all, the number of people who truly understand the accounting of repo in the entire world can be counted on one or two hands.
Furthermore, not helping matters is that the guidelines for repo accounting in FAS 140 actually contradict themselves! Recall, from Matt King’s “Are The Brokers Broken” when explaining the mechanics of “borrowed versus pledged” transactions:
Quite apart from the fact that FAS 140 contradicts itself (with paragraph 15 (d) making borrowed versus pledged transactions off balance sheet, and paragraph 94 making them on balance sheet, a topic complained about by many broker-dealers immediately after its issue), there seems to be little consensus as to who is the borrower and who is the lender. As far as we can tell, terms like ‘borrower’ and ‘lender’ are used in exactly the opposite sense in the accounting regulations relative to standard market practice. The description above follows common market practice. The accounting documents seem to refer to this the other way around, a source of confusion commented upon in some of the accounting literature.
What makes things very scary is that the main reason to use repo is to avoid putting down cash or pledging assets in the form of a conventional loan. And since all of Europe is now asset strapped, virtually every insolvent banking system, be it Italy’s or Spain’s is now entirely reliant on repo: in short every single European bank is one massive MF Global-type blow up just waiting to happen.
And with peripheral European banks using repo to buy up as much sovereign bonds as they can, one thing is assured: once sovereign bond yields start blowing out, the liquidating cascade will commence, as margin call after margin call saps the collateral counterparty chain of any excess liquidity, forcing the ECB to finally not only use the OMT, but since the OMT is one big mirage which doesn’t exist from a legal standpoint, to directly inject cash into countless banks: a move which Germany will just love.
However, for now why worry?
After all the BOJ’s massive QE came just at the right time to find the next big marginal buyer of peripheral debt alongside domestic PIIGS banks (most likely just as the capacity for repo was about to be maxed out). The immediate result has been the epic and near record in many instances, tightening of peripheral spreads. Alas, they can only go to zero, before someone sells. And then someone else sells, and the carry trade unwinds.
Sadly, the last in this unwind chain will be the suddenly once again very much insolvent Italian and Spanish banks who will then have to once more get full taxpayer defaults while waving the Mutual Assured Destruction card.
The only question is when. However, if Abenomics does indeed suffer an early death due to program failure or whatever other reason, that will be the time to bolt the hatches and lower the periscope as the marginal buyer of European toxic hazard will be gone, and the European banks will have no choice but to dump it all, finally setting off the endspiel of the European crisis.