Takeaways from Citi's Distressed Desk Analysts (Average Returns, Cash Balances, MF Global)

Yesterday, Citi kicked off its 2011 North America Credit Conference. As usual, Citi provided a strong offering of management presentations across the credit spectrum as well as many fascinating panel discussions (just to name a few: Global CDS Central Clearing Update, 2012 Implications of Dodd-Frank and Changes to the Banking Regulatory Scheme, a high yield panel, etc). Most relevant to us, Citi's distressed desk analysts presented a variety of actionable ideas to a large audience of distressed debt investors.

Before the analysts discussed their investment ideas, Rohit Bansal, the head distressed trader at Citigroup, kicked off the discussion with a few interesting observations. First, he noted that after to speaking to a number of clients, the average distressed fund was ranging from -5% to 2% in terms of return for 2011. Second, he noted that there was a significant amount of cash waiting on the sidelines, to the range of 25-40%. The "pain trade" as it were is making accounts want to wait until there is more clarity on the macro scene before risking capital. He did note that funds with locked up, long-term capital will be more willing to bid on blocks whereas funds beholden to redemption risks are significantly more cautious.

Next, Marc Heimowitz, Head of Credit Special Situations, touched on an issue that is plaguing the entire investment community: Markets are being driven by macro exogenous risks. In theory, the issues in Greece should not affect the fundamentals of numerous businesses in the United States, but those same issues are dramatically affecting the pricing of underlying securities.

He then moved on to the level of dealer inventory. Here is a chart from Bloomberg:

You can see the precipitous drop since the 1H of this year. What makes this chart even more frightening is when you compare the above to the amount of total corporate debt outstanding which rises year after year after year. This effectively means that the amount of dealer inventory over the amount of corporate debt outstanding is near decade lows.

Personally, this is making execution all the more difficult and dealers (rightly so) are having to make wider markets less they be picked off by aggressive accounts. He closed by nothing they think Lehman's recovery falls into the 31-32 range with a 1 year average life (versus a market near 25.5).

Next, the distressed desk analysts each presented an actionable long / short idea from the variety of their coverages. While, I will not list each of these ideas (contact your Citi sales coverage for the list of ideas), I did want to to touch on one idea in particular, especially given the price action today: MF Global.

We first introduced MF Global's bankruptcy a few weeks ago. Since then, the broker-dealer has been placed into liquidation, a creditor committee for the holding company has been named, and many, many buy side analysts still are doing the hard work to value the recovery to creditors. This price action since the bankruptcy has been anything but stable:

Bonds were up 6 points today, driven by three reasons (in my opinion and listed in reverse chronological order)

• Creditor Committee counsel, Martin Bienenstock (Dewey & LeBoeuf), said in court: "We think there is potentially quite an estate to be amassed here for the benefit of creditors."
• Rumors that Appaloosa had been buying bonds in the mid 30s according to unnamed sources
• Rina Joshi, Citi's distressed desk analyst covering MF, laying out a case that the bonds could be worth between 50 cents to par at Citi's credit conference yesterday.

Rina presented a compelling case and I had the feeling, given the size of the crowd in attendance, the bonds would be up with the pitch. They started the day up 2-3 points and then really rallied into the close as the case proceedings heated up.

Rina first noted, and I think everyone covering the MF situation understands deeply, that there is significant missing info and much of the info analysts are working with is dated (for instance, the last broker-dealer financials we are working with are from 3/31). In essence, the bond (and bank debt) will receive value two ways: 1) inter company receivables and loans 2) equity from subsidiaries, both domestic and abroad.

Most people I speak to have been deconstructing the balance sheet by matching assets and liabilities, and then applying a "friction cost" or haircuts (to both sides in some instances) to come up with equity value that, in theory, should flow up to the intermediate finco and the ultimate holding company. A basis for this is that according to the most recent data we have, MF Global had VERY few Level 3 assets and thus, again in theory, friction costs should not be onerous to the recovery of the estate(s).

Rina demonstrated this with a variety of assumptions of the level of haircuts which restulted in a par recovery for a small levels of haircuts and lower recoveries for larger haircuts for a range of 50-100 cents on the dollar. These levels have to then be discounted depending on your hurdle rate and how long until you expect to receive distributions. Ultimately, and I think this was my biggest takeaway, she noted that the trading level of the bonds imply $2.6B of equity was lost at the organization which she seemed to be aggressive. She did note that if the $500M+ of missing funds were not recovered, this would ultimately affect recoveries on the order of 20-30 cents, but she believes that money is somewhere in the system.

For full disclosure, I have yet to establish a position in the name, despite a nagging feeling that recoveries will be north of 50 cents here. ~$600M doesn't simply just go missing, assets were seemingly liquid, and some people I've spoken to say that a number of the overseas operations are amazing assets that will flow equity to boost holding company recoveries. The needle moves VERY quickly on this one given the leverage (i.e. an assumption of 1% friction costs to 2% friction costs greatly reduces recoveries). I continue to work through the issues and hopefully when the first MOR hits, I'll be able to update my model and share with readers. If you are working on this one, would love to hear your thoughts.

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Distressed Debt: MF Global Bankruptcy

This morning, MF Global filed for Chapter 11 bankruptcy protection in SDNY. For those interested in following along, the Claims Agent page can be found here:

MF Global Claims Agent Site

And the actual bankruptcy docket can be found here:

MF Global Bankruptcy Docket

Over the weekend, I heard from analysts and traders that MF Global was shopping their corporate bond portfolio via a dealer to large buy side institutions. This portfolio was not large to any extent, but it seemed like a desperation act that portended talks falling through. Then this morning, with the announcement from the New York Fed and ICE it was simply a matter of minutes before the filing was coming down.

For those interested, here is the intraday chart for the 6.25% of 16'"

I'd like to call that a wild ride. Initially it felt like short covering, then felt like people were buying a few bonds here and there to get involved. Of course, all this action happened before the New York Times reported that hundreds of millions of dollars in customer money has disappeared in the last few days (Update Tuesday morning - bonds opening 36-40 ie down 10-15 points):

"Federal regulators have discovered that hundreds of millions of dollars in customer money have gone missing from MF Global in recent days, prompting an investigation into the company’s operations as it filed for bankruptcy on Monday, according to several people briefed on the matter.

The revelation of the missing money scuttled an 11th hour deal for MF Global to sell a major part of itself to a rival brokerage firm."

For those that want to get into the gritty details, here is the org chart for MF Global:

To be fair, I am using the term "MF Global" too liberally. In fact, the SDNY filing is for MF Global Holdings, Ltd. (i.e. the ultimate holding company), and MF Global Finance USA Inc. (i.e. the intermediate holding company). Subsidiaries in the UK and Australia have also filed for their respective protection. On the other hand, MF Global, Inc, which is, in fact, the actual broker dealer, has not filed.

There are many, many flavors to play in MF Global:

• Holding Company Bonds: 1.875% converts, 9% converts, 6.25% senior uns (priced in August!), 9% senior uns (NOT guaranteed by subsidiaries)
• Extended and Non-Extended Revolver (2014 and 2012 respectively) (NOT guaranteed by broker dealer, but issued out of MF Global Finance USA Inc and the holding company as co-borrower )
• Secured Revolver of 2012 (at the broker dealer, and also guaranteed by holdco and intermediate holdco)

How did this all start? While I'm not going to blame "reaching for yield" on the filing itself, you have to wonder about some of the moves here. From the filing:

On September 1, 2011, MF Holdings announced that FINRA informed it that its regulated U.S. operating subsidiary, MFGI, was required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MFGI increased its required net capital to comply with FINRA’s requirement...

Dissatisfied with the September announcement by MF Holdings of MFGI’s position in European sovereign debt, FINRA demanded that MF Holdings announce that MFGI held a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity, including Belgium, Italy, Spain, Portugal and Ireland. MF Holdings made such announcement on October 25, 2011. These countries have some of the most troubled economies that use the euro. Concerns over euro-zone sovereign debt have caused global market fluctuations in the past months and, in particular, in the past week. These concerns ultimately led last week to downgrades by various ratings agencies of MF Global’s ratings to “junk” status. This sparked an increase in margin calls against MFGI, threatening overall liquidity.

In actuality, back in May, MF Global listed $6.3B in holdings in European sovereign debt in their 10K. In their recent earnings call, the company laid out specifically what they owned:

Here is what Jon Corzine said on their Q2 2012 earnings call just last week:

"Now let me turn to a subject which has understandably clouded perceptions with respect to our profits, that is our repurchase to maturity sovereign positions as noted on slide five. As we have pointed out over the past year in our disclosures and quarterly calls, we have taken advantage of the dislocations in the European sovereign debt market by buying short dated debt in European peripherals and financing those securities to their exact maturity date. Therefore, the term repoed to maturity.

The spread between interest earned and the financing cost of the underlying repurchase agreement has often been attractive even as the structure of the transaction themselves essentially eliminates market and financing risk. At the inception of these positions, we made the judgment that the securities we financed to maturity would repay, given their high credit rating and short duration – that is all securities mature before 12/31/2012 – and later reinforced by the commitments of European and international institutions in supporting the solvency of the issuing countries. Again, in the timeframe of our exposures, the full RTM portfolio we hold is seen on slide five. We specifically tiered the maturity of our holdings to reflect credit ratings at the time of inception, and reassessed our risk based on the EFSF and IMF support programs, that significantly enhanced the probability and the ability of Portugal and Ireland to meet their obligations on schedule, again, within the context of their maturities, in Ireland and Portugal's case, June 2012.

The positions in our portfolio of higher rated countries, Italy, Spain and Belgium, have also benefited from support from European institutional actions, although not direct solvency packages. These same countries' credit positions are now the subject of the ongoing public debates taking place regarding future systemic support from the European community. Again, in the maturity timeframe of our holdings, 12/31/2012, we expect any of the actions proposed to give additional support to an already strong probability and ability of these nations to meet their obligations.

So, in short, our judgment is that our positions have relatively little underlying principle risk in the timeframe of our exposure. We continually reassess that judgment and are prepared to take offsetting actions if conditions or circumstances change. We are not adding to this portfolio and we will allow it to roll off as the staggered maturities are reached. I would also note that we carry little exposure to these countries' banking systems and no derivative exposures dependent on a country's credit worthiness.

In addition, consistent with prior quarters, there is no mark-to-market associated with the derivative value of these positions.

Overall, the Debtor stated in the disclosure: "Debtors submit that the Company had consolidated assets and liabilities, as of the quarterly period ended September 30, 2011, of approximately $41.0 billion and $39.7 billion, respectively."

Here is what is concerning to me: The automatic stay does not cover repos in bankruptcy. In effect, the counterparties to MF Global's $6.3B European investment, or any other asset financed with secured repo, could go out in the open market and sell it to get their money back. Given the amount of leverage here ($41 billion of assets, versus $1.3B of equity), it doesn't take many trades at 95 cents on the dollar to wipe equity away from the firm.

Another interesting tidbit: Skadden Arps who is representing MF Global in the Chapter 11 filing also represented Refco during its bankruptcy. Man Group won the bankruptcy auction of Refco's customer accounts paying 7 cents on the dollar per customer account ($323 million total consideration). Man Group then spun out MF Global in 2007, so in effect we are all at the Refco assets once again.

For those looking to brush up on your Refco knowledge: Key Refco Bankruptcy Documents

The problem with a situation like this is that the longer it takes for the company to sell all or parts of its business, the faster the business value declines. But there is value here if customers stay. MF Global can be thought of two different sorts of businesses: A broker dealer and a futures commission merchant. To me, the value really lies in the futures commission merchant as we've seen a number of broker dealers shutter its door in the past few months, and any potential purchasers would have to take the aforementioned Eurozone sovreign risk. On mitigating factor here though is that as customer accounts leave the door, assuming no mark down on repos sales, MF will be required to hold less capital. In fact, if MF sells its entire futures business, it could free up a substantial amount of capital depending on how the deal was structured.

Complicating things further are the subordinated intercompany loans granted to the broker dealer from MF Global, LTD ($130M) and MF Global Finance USA Inc. ($425M). These are assets of these entities and assuming residual value flows up from MF Global, Inc, this would factor into the recoveries of the various securities -> hence why the extended and non-extended revolver are trading at a premium to the unsecured bonds and converts (i.e. the credit facility benefits from the MF Global Finance USA Inc.'s $425M intercompany loan whereas the bonds do not).

Net / Net, I'm still working through this one (and jamming on the Tribune decision, which I'll post on tomorrow). Questions I am working on really revolver around a range of values for both the future commissions merchant and the broker dealer (which ultimately depends how many accounts are still in the building as it were) and how a sale could free up required capital.

If you are working on this one, would love to hear from you. Fun times.

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