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Let’s talk about Jefferies for a bit. Jefferies is a wee broker-dealer who briefly traded down 20% this morning though they got better. They have some problems that they like talking about because they aren’t really problems (being long $9mm of MF Global bonds), and some problems that they don’t like talking about because they’re maybe small deep holes and also kind of embarrassing (missing problems at MF Global repeatedly when underwriting and considering buying it).
Then there’s the problem that they have to talk about, even though it’s maybe not a problem, and it goes something like this. They have $2.7 billion gross long exposure to sovereign debt, or 77% of their book equity. That’s bad. They have $38 million net short exposure to PIIGS debt, or 1% of their book equity. That’s good.
There are about three things you can think about that information:
1. They are long 77% of their equity in sovereign debt, and short 78% of their equity in sovereign debt physical (i.e. by borrowing and shorting bonds), with reasonably matching duration and issuers on the long and short sides.
2. They are long 77% of their equity in sovereign debt, and short 78% of their equity in sovereign debt by buying CDS from a carefully diversified set of counterparties who are all rated AAA at at least five ratings agencies including Egan-Jones, who are totally uncorrelated from each other and from any European country, none of whom account for more than 1% of JEF’s exposure, who all post hourly mark-to-market margin in cash equal to 200% of exposure, and on whom Jefferies has bought CDS in an amount equal to the maximum exposure from counterparties who … [turtles].
3. They are long 77% of their equity in PIIGS debt, and short 78% of their equity in PIIGS debt by buying uncollateralized CDS from Soc Gen or Dexia or The Ghost of AIG Past.
If you think #1 then you probably bought the dip. If you think #2 then you probably did too, though maybe the turtles worry you. If you think #3 then you are freaking out. You may be doing so unreasonably – maybe PIIGS bonds will be fine, maybe Soc Gen will pay out no problem – but if you think #3 then you’re the type who just likes to worry.
Given Jefferies’s meltdown this morning, a lot of people must have thought that the answer was #3. But the actual answer pretty clearly seems to be #1: JEF is long $2.68bn in physical bonds and short $2.55bn in physical bonds, at market value as of 9/30, per their 10-Q. As for their derivatives, they are not mostly on sovereign credit, or on credit at all:
Now, that doesn’t mean that Jefferies is impervious to PIIGery – the Q doesn’t discuss duration; nor does it discuss funding of those positions. Jefferies today has said that the shorts and longs have “matched maturity” and that the positions are in trading accounts and turn over frequently, which should probably make you feel better.
But you probably shouldn’t have felt that bad to begin with. The fact that long and short market values matched, and that Jefferies has no meaningful credit derivatives exposure long or short, was in the 10-Q they filed last month. If you believed this morning that their $2.7bn gross exposure was ($38mm) net only because of opaque CDS with shaky correlated counterparties, then either you hadn’t read their Q or you thought it was lying.*
Now, why would you think that? Possibly because you had recent experience of a smallish broker-dealer hiding the ball a bit on European exposures and the hedging thereof?
Yeah, but also because so much of the story of recent markets is banks saying “our net exposure is trivial” and then people getting a bit freaked out that “net” exposure is true only for certain values of “net” – when your counterparties come through, your collateral equals your exposure even in a jump case, etc. (Or a lot freaked out.) And that worries people because it’s pretty much the story of AIG: you’re hedged until you find out that everyone was hedged with the one guy on the other side of the trade.
Banks tend to say things like “we’re diversified” and “Counterparties are predominantly investment-grade global banks domiciled outside the Euro 5.” And ISDA is adamant that (1) net exposure is the only thing that matters, (2) it’s all collateralized anyway, and (3) you’re an idiot if you think otherwise. But those assurances aren’t so reassuring – the more you call anyone who questions you an idiot, the more you sound like you have something to hide.
And the information that you and I can get on this subject is not particularly great: you can look at freakout gross numbers, or soothing net numbers, and not much in between. Inquisitive people would like to see the CDS data repository be a bit more granular to allow you and me and the people who sold JEF today to have some sense of how much concentrated risk there is and how much of that netting is really nettable in a meltdown.
Which would be great. But that repository was set up mainly to help regulators, not bloggers, examine those concentration risks. If you had a trusting view of financial markets, you’d have to feel pretty good about this. Counterparty risk is reviewed at two levels: banks have every incentive to carefully curate their exposures in order to avoid, y’know, losing lots of money. And regulators have every incentive to check that those exposures are safe because preventing banks from melting down is pretty much their job. With aggregated and trade-by-trade data, it should be relatively easy to do. A further layer of review from customers, investors and the media isn’t necessary. Right?
The fact that Jefferies lost 20% of its market cap this morning, albeit briefly, is pretty damning for that cheerful view. Nobody trusts broker-dealers, or their regulators, to make sure that their hedges hedge. Even when the mechanics of those hedges are clear – and clearly functional – from the public disclosure. My suspicion – and I don’t have a controlled experiment – is that this is particularly true for non-too-big-to-fail broker-dealers like Jefferies, but it’s at least a little true for everyone.
It’s pretty unfair that Jefferies got tarred with this – their netting probably really nets (though, again, exact duration and funding numbers are unclear), doesn’t carry counterparty risk, etc. Yes they’re a bit leveraged at 12ish:1 (comparable to GS and MS), but they’re basically a vanilla broker-dealer who make their money on interest, commissions, and investment banking fees. And they just didn’t have any real euro CDS exposure.
Unlike MF, which seems to have gone belly-up in part the old-fashioned way, by losing track of customer money, Jefferies could be a pretty nice canary in the coal mine – or something less violent, like, I don’t know, a functioning ventilation system in the coal mine. Despite having done pretty much everything right about its European exposure, JEF’s stock had enough of an accident to halt trading. And then it mostly recovered, no harm no foul. But its freakout is a good reminder of how little markets trust either banks or regulators to manage their credit exposure, and how little statements like “we are hedged” or “we have diversified counterparties” are likely to help when someone starts throwing stones. Jefferies recovered in large part because they had publicly available, SOX-certified data that quite clearly sets out how their hedges work even in an all-correlations-to-one environment. That’s a good thing for other banks to prepare for.
* Or you think that since the Q they took off $2.5bn of cash short positions and added $2.5bn of synthetic shorts, which would be … an odd trade to put on last month.