MF Global Was A Primary Dealer

This bit was interesting.  MF Global was a Federal Reserve “Primary Dealer”.

In a research note published Tuesday, Steve Blitz, a senior economist with ITG Investment Research, pointed out that MF Global was one of the firms designated by the Federal Reserve as a primary dealer in U.S. Treasuries. After the havoc of high leverage in the financial crisis, how is it possible that the Fed allowed MF Global to operate with so much leverage?

The Primary Dealers have the perk of borrowing directly from the Federal Reserve at the Fed Funds Rate, when the Federal Reserve “monetizes the debt”.

The Primary Dealers get to borrow at a cheaper interest rate than everyone else.  This is extra profit opportunity.

The Primary Dealers can borrow for 0.1% or so cheaper than everyone else.  With 100x leverage, this 0.1% edge gives 10% sure profits.

Therefore, a Primary Dealer should load up on leverage.  With access to cheap money, they can make trades that would be unprofitable for banks with higher borrowing costs.

That’s what bankrupted MF Global.  They loaded up on leverage, buying European bonds, and then were wrong and went bankrupt.

The blame for MF Global’s bankruptcy lies not just with MF Global’s management.  The blame also lies with the Federal Reserve.  The Federal Reserve keeps interest rates much lower than true inflation, giving banks an incentive to load up on leverage.  As a Primary Dealer, MF Global got to borrow more cheaply than everyone else.

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