Sheila Bair, former head of the FDIC and cartoon-klutz-villain of Too Big to Fail, comes in for the occasional gentle ribbing on Wall Street, and her column in Fortune today is well set up for another round of gentle ribbing, which I will get to in just a minute, so you might think that that headline was intended to make fun of her, but actually, no, she makes a solid point:

MF Global took proprietary positions in European sovereign debt through what Wall Street calls “repo to maturity” transactions. It technically sold the European bonds to other firms, agreeing to repurchase them at a premium when they matured in 2012. MF hoped to make money by pocketing the difference in the rate it paid its trading partners and the higher rate paid on the bonds themselves. … Under the 300-page Rube Goldberg contraption of a regulation recently proposed by federal agencies to implement the Volcker Rule, “repo” transactions like MF Global’s are not generally treated as verboten proprietary trades. Thus, even if MF Global had been a bank, it arguably could have used this exception to gamble away, putting the FDIC at risk.

Now, if I had to guess, I’d say the better side of the argument is that the MF sovereign trades would in fact be streng verboten under the Volcker Rule. (Except, of course, as she points out, that MF is not an FDIC insured bank and so is not covered by the Volcker Rule.) I read the rule’s coverage of “any long, short, synthetic or other position” in a security to include the Corzine repo-to-maturity, which is at least a “synthetic position” in the underlying debt, and since the position seems to have been more “prop” than “flow” it would probably be prohibited. But I had to search around in the proposal for some time to come to that conclusion – it’s not apparent even from the mammoth Davis Polk flowchart that has replaced the actual rule text for my day-to-day Volcker Rule pondering efforts. And the meaning of “synthetic” may not be the same to everyone. So I’ll spot her the claim that a bank could “arguably” use a repo-to-maturity structure to prop trade to its little heart’s content. [Update: A lawyer I trust points to the Volcker Rule's "repo exception" for trades arising out of repo agreements; he thinks that Bair is right that the MF Global trades would fall under the exception and not be covered by the rule. I suspect that the intent of the "repo exception" is to cover the people providing the repo funding (here MF's counterparties), not the people with economic exposure to the position, so I'll tentatively stick to my original claim, but in any case the murk is even murkier than I'd thought. By the way, if I'm wrong, then things are even worse than Sheila Bair thinks. Basically any prop trade is fine as long as you fund it via repo.] Continue reading »