U.S. regulators started raising concerns about now-bankrupt MF Global's European sovereign debt exposure as early as June, according to a source familiar with the matter.
The full extent of the futures brokerage's big bets on the recovery of European debt only emerged in recent weeks, as MF Global revealed in public filings that it had a long position of $6.3 billion in short-duration European sovereign debt -- roughly five times the firm's book value, or net worth.
Concerns about the firm's debt exposure then ballooned, prompting ratings firms to downgrade MF Global to junk, which triggered margin calls and threatened the firm's liquidity.
When attempts to find a buyer failed, MF Global filed for bankruptcy protection on Monday.
The collapse played out quickly, but regulators started turning the screws on MF Global months ago.
Around June, the Financial Industry Regulatory Authority (FINRA), one of many regulators that policed the firm, became concerned that MF Global had a substantial position in European sovereign debt and was not appropriately holding capital against it, the source said.
FINRA, which regulates the securities-brokerage arm of MF Global, began conversations with the firm about whether it was appropriate for it to use Generally Accepted Accounting Principles (GAAP) to park the exposure off balance sheet, according to the source, who was not authorized to speak publicly.
The firm was financing its European sovereign debt bets through repo-to-maturity transactions, which allowed MF Global to move the exposure off its balance sheet, despite the firm still facing enormous risk in the case of a default.
Essentially, MF Global borrowed against the bonds until they matured, and earned money from the difference between the yield on the bonds and the rates they were paying on their financing. At maturity, the principal from the maturing bonds would be used to repay the money used to finance the purchase.
FINRA felt that regardless of GAAP, MF Global should take a haircut on the sovereign debt-related holdings, and consulted with the U.S. Securities and Exchange Commission, the source said.
After lengthy conversations with FINRA and the SEC, MF Global yielded and infused the additional capital called for, something the firm disclosed on September 1.
In its own account of its collapse, MF Global repeatedly points to regulators as having a critical role in triggering the crisis of confidence in the firm.
In an affidavit to the bankruptcy court on Monday, MF Global President and Chief Operating Officer Bradley Abelow lays out the FINRA-mandated capital change as the first item in Events Leading To Chapter 11 Filing.
(Reporting by Sarah N. Lynch; Editing by Tim Dobbyn)