Concave Loss Function

It’s all downside risk discussions today.

First there’s Corzine:

Izabella Kaminska has the wonky details of MF Global’s repo-to-maturity trade. It’s not easy to follow, but here’s the general gist. MF Global buys a bunch of European debt. The bank’sexplanation of the trade says that the purchases were “entered into repurchase and reverse repurchase transactions to maturity, which are accounted for as sales”. This is the repo-to-maturity trade.

In order to understand what that means, you first need to understand that banks like MF Global used to do nearly all their borrowing on an unsecured basis. But in recent years, that’s changed: nowadays, if you want to borrow billions of dollars for what MF Global calls “client facilitation and principal activities”, then you’re going to need to put up collateral.

So as soon as MF Global bought those bonds, it turned around and pledged them as collateral when it was borrowing money. That’s the repo.

Now here’s the trade: the rate at which it was borrowing money was lower than the coupon payments on the European sovereign bonds. And because this was a “repo-to-maturity”, MF Global was essentially locking in the difference as profit. It got to keep all the coupon payments, while it had to pay out something less than that in interest.

And here’s the money quote from Felix’s source:

Either way, a fall in the value of the bonds could create a major liquidity drain for MF Global. Though these sorts of liquidity risks should have been accounted for in VaR calculations. Much harder to anticipate would have been a complete disappearance of willing counterparties.

Facepalm!

Even better, Europe is EFFED:

Make no mistake about it, the decision to hold a “referendum” is a decision to turn down the deal altogether.

Why, you ask? Well follow the money! Greek banks go bankrupt when the bonds default, Greek pension funds go belly-up when the bonds default.

The Greek gov’t then needs to borrow tons more money to replenish the pension scheme, or maybe toss the old-timers into the street? It’s going to come down to that.

Naw, they’re going to exit the Euro. Gotta be a surprise or it won’t work. The contagion will rip through any other country that doesn’t get a blanket guarantee from the ECB. By contagion rip through, I mean massive shorting of government debt, bank debt and a ha-uuuuge increase in borrowing costs for weaklings, which may well drive them into default themselves.

But we’re not at the end game yet, kids. Perhaps still months away!

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