Counterparty Risk Trips Up MF Global

The New York Times DealBook blog just put out a fine piece on the collapse of MF Global: A Romance with Risk That Brought on a Panic by Azam Ahmed, Ben Protess, and Susanne Craig (December 11, 2012). It’s the most comprehensive summary of the events that led to the firm’s bankruptcy that we’ve seen so far. Until the investigations are done and the books are written, it’s a good source for thinking about the credit risk lessons to be learned in MF Global’s sad story. MF Global seems to have made a lot of risk management mistakes. It took on a big dose of market risk with its $6.3 billion exposure to the European debt crisis – over the objections of its senior risk manager. With only $1.4 billion in capital, the company could barely afford to take any losses. There may have been operational risk issues at the firm as well. About $1.2 billion of client money has gone missing, and after weeks of searching the company’s records it’s still not clear where most of it is. At best, this is a serious systems failure; at worst, it could be a lot more sinister. But the fatal risk at MF global was a form of credit risk called counterparty risk. That’s the risk that a firm involved in a trade fails to pay what it owes. Counterparty risk is where market risk and credit risk intersect: as a company’s trading losses grow, its ability to pay decreases. Moody’s downgraded MF global from Baa2 to Baa3 in October, citing exposure to European sovereign debt, a regulatory capital shortfall,...

Margin Call

There have been movies about finance before: Wall Street and Wall Street: Money Never Sleeps, for instance. There are films about the financial crisis as well: HBO’s Too Big to Fail. But the best movie about finance has to be Margin Call, just out in theaters and available on iTunes and at Amazon. It’s a fictional account of a Wall Street firm’s effort to save itself from a massive trading loss in mortgage backed securities. The writing is crisp, compelling, and completely authentic. The characters aren’t Occupy Wall Street caricatures of evil bankers; they have real dimension. They’re callous and loyal, principled and greedy, ruthless and erudite all at once. Best of all, Margin Call is the only movie we know that features risk and the people who manage it. And the risk managers are played by Stanley Tucci and Demi Moore! We loved it, but don’t take our word alone. According to Rotten Tomatoes, critics and audiences loved it too. So we recommend you go long on Margin Call and invest a few hours of your valuable time watching Kevin Spacey, Paul Bettany, and Jeremy Irons struggle with understanding and dealing with...

Early Warning Signs at Borders Part 2

It may be disappointing, but it can’t be surprising that Borders Group went bankrupt this week. It was clear some time ago the company was heading deep into distress. What made it so clear? The six classic early warning signs of financial distress. We covered the first three in our last blog post. Here’s a brief video about the last three. [youtube...

Early Warning Signs at Borders Part 1

We blogged about Borders Group back on January 4. Even though the company has a new financing commitment, it continues to have problems paying suppliers. It looks like Borders is still circling the drain. Borders’ survival is questionable, but for us the more interesting question is, “How could we have have seen the trouble at Borders coming?” What were the warning signs of Borders’ distress? In this video post we talk about three of the six early warning signs of financial distress and see how they apply to Borders. We’ll talk about the other three in our next post. [youtube SXjauKH5s7c] Early Warning Signs Part...

Borders circles the drain

The Wall Street Journal reported yesterday that Borders Group Inc. was halting payments to some suppliers, and that one publisher had stopped shipping books to Borders.  The end is near.  As we discussed in an earlier post, if trade creditors lose faith in a company, bankruptcy is almost unavoidable.  The term we use is “confidence sensitive cash flows,” which includes, in addition to trade credit, short term borrowings like commercial paper (think Lehman Brothers) and counterparty credit (think Bear Stearns).  Once one supplier stops shipping, they all will stop. Today, the Wall Street Journal reported that two senior executives had resigned (the General Counsel and the Chief Information Officer).  This is another classic early warning sign.  Let the countdown begin...