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The 'repo-to-maturity' game

Updated Wednesday, 1st May 2013

The collapse of MF Global not only exposed the vagaries of the ‘Repo-to-Maturity’ game, but also the issues posed by the application of different accounting standards

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When the financial services firm MF Global went into bankruptcy in 2011 the wider public started to learn about another way financial institutions could place large bets in the financial markets - and lose catastrophically!

This time the game being played in the financial markets casino was called ‘repo-to-maturity’. The collapse of MF Global not only exposed the vagaries of this ‘game’ but also the issues posed by the application of different accounting standards across the financial world.

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First, what are ‘repo’ transactions and what is ‘repo-to-maturity’?

Repo is an abbreviation for ‘repurchase’ and repo transactions are really just a form of secured borrowing. This entails using collateral to support the borrowing of money - rather like the way mortgages are secured on the properties being purchased by households.

Each day in the world’s money markets huge volumes of repo transactions take place in a range of currencies.

In a repo transaction, one party borrows cash from a second party for a defined term – say three months – and at an agreed interest rate known as the ‘repo rate’. To provide security against the money borrowed the borrower sells the lender bonds (usually government bonds, given their high credit worthiness) with a market value of at least that of the sum of cash borrowed.

Simultaneously, at the inception of the deal, the borrower agrees to repurchase (‘repo’) the bonds on the maturity of the repo transaction at an agreed price. Note, though, that during the life of the transaction the interest earnings from the bonds used in the repo transaction are retained by the party borrowing the cash.

If the borrower goes bust during the term of the repo transaction the lender will get their cash back by selling the securities provided as collateral. If, during the course of the repo transaction, the market value of the bonds held by the lender as security falls below the value of the cash lent then the borrower has to provide more collateral to the lender – this is known as a ‘margin call’.

The only thing that is particularly distinct about a ‘repo-to-maturity’ transaction is that the maturity date for the money borrowed matches precisely the maturity date of the bonds provided as collateral. On that date both the cash part of the deal comes to an end and the bonds reach their maturity date, with the bond issuer making repayments to those holding its bonds.

In 2010 MF Global came up with what they thought was a cunning plan to use repo-to-maturity to boost their ailing profits. They bought up the bonds issued by the governments of those countries in the euro zone that were in financial difficulties.

These provided a high return to investors given the risks inherent in investing in them. MF Global then entered into repo-to-maturity transactions using these bonds – borrowing cash against the collateral of the European government bonds.

In effect this cash was used by MF Global to purchase the bonds that they then repo-ed. The repo deals ran to the maturity of the bonds.

Since the repo-rates on the cash borrowed by MF Global in the repo-to-maturity transactions were lower than the interest earnings for MF Global on the bond holdings a huge profit was, ostensibly, achieved on these transactions.

However, this cunning plan came unstuck. As the crisis in the euro zone went from bad to worse in 2011 the market value of the bonds provided as collateral under these repo-to-maturity transactions tumbled.

MF Global’s counterparties therefore made margin calls aimed at restoring the value of the collateral held against the cash they had lent MF Global. This was allegedly met, at least in part, by MF Global providing cash that had deposited with them by their investment clients.

Given the billions of pounds involved in these deals MF Global soon, however, ran out of capacity to finance the margin calls thereby putting them in default on their repo-to-maturity transactions. As a result MF Global had to file for bankruptcy.

So the clear evidence is that repo to maturity is not a risk-free financial manoeuvre. If the collateral falls in value the borrower in a repo transaction has to put up more security in the form of more bonds, cash or other assets.

Under US accounting rules MF Global was able to book the apparent profits it had made on its repo-to-maturity deals upfront and take the transactions off its balance sheet.

This cannot happen under the International Financial Reporting Standards (IFRS) rules applied in Europe where the repo trades are shown as secured lending, with the repo positions being retained on the balance sheet and with full recognition of any profits only occurring on the maturity of the deals.

Arguably MF Global took the decision to move its repo-to-maturity trades to its US entity to benefit from the less transparent accounting treatment availed under US accounting standards.

Interestingly MF Global was originally established as a barrel maker in London! Those establishing the company in 1783 could never have envisaged the nature of its fate 228 years later!

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