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I've been promising to give an illustration of the shenanigans being played by the commercial and investment bank's for some time now, but I've been quite busy working on my entrepeneurial pursuits and paperwork. It is unfortunate that I have to call it "entrepeneurial pursuits" instead of just stating what it is, but the regulatory powers that be don't think you can handle it. I will coddle stuff together from email discussion, news clips and my prop models to hopefully explain why I'm still so bearish on the banking sector.


In recent months, the financial crisis sparked by subprime-mortgage problems has jolted banks and sent Libor sharply upward. The growing suspicions about Libor's veracity suggest that banks' troubles could be worse than they're willing to admit.

The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That's good for borrowers, but could be very bad for the banks and other financial institutions that lend to them...


The global financial crisis that began last summer has made it more difficult for banks to package and sell all kinds of loans as securities, as well as to issue bonds and short-term IOUs to investors. Increasingly, banks have turned to the interbank market to borrow cash. But their mounting losses on mortgage securities and other investments have raised fears that a major institution could go bust. That's made banks increasingly wary of lending to one another.


Such jitters have made many banks unwilling to extend loans to each other for more than one week. As a result, the rates they quote for loans of three months or more are often speculative, because there's little to no actual lending for that time period, brokers say. "It amounts to an average best guess," says Don Smith, an economist at ICAP, the London broker of interbank loans and derivatives.

These bank problems are proving costly to other kinds of borrowers around the world. One way to measure the rough cost is by comparing the three-month Libor rate with an interest rate that doesn't reflect worries about banks' financial health -- such as the yield on a three-month Treasury bill, which is backed by the U.S. government. The gap between the two stood at 1.58 percentage points Tuesday, and has averaged 1.39 percentage points since the crisis began in August. In the five years before the financial crisis started, it averaged only 0.28 percentage points.

Citigroup's Mr. Peng believes banks could be understating even those abnormally high Libor rates. He notes that the Federal Reserve recently auctioned off $50 billion in one-month loans to banks for an average annualized interest rate of 2.82% -- 0.1 percentage point higher than the comparable Libor rate. Because banks put up securities as collateral for the Fed loans, they should get them for a lower rate than Libor, which is riskier because it involves no collateral. By comparing Libor with that indicator and others -- such as the rate on three-month bank deposits known as the Eurodollar rate -- Mr. Peng estimates Libor may be understated by 0.2 to 0.3 percentage points...

... In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said that banks might have an incentive to provide false rates to profit from derivatives transactions. The report said that although the practice of throwing out the lowest and highest groups of quotes is likely to curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient number change their behaviour."

In another story regariding the Lehman packaging of leveraged loans to sell ,sorry about that, I meant "lend" to the Fed, in order to monetize trash that it couldn't dump in the market, from WSJ:


 Was It 'Brilliant'?

One person familiar with the matter said the vehicle was named Freedom because it was designed to give Lehman freedom to tap as much cash as possible if needed. The size of the borrowing from the Fed wasn't known, but the person said it wasn't "material" and was meant as a test of what the Fed would accept.

The loans in the pool included debt that was issued to finance last year's leveraged buyouts of First Data Corp. and TXU Corp., a person familiar with the matter said.

A number of Wall Street executives called Lehman's move "brilliant" and said they may follow suit. One senior finance executive at a rival of Lehman's said his main reservation with Lehman's move was that it might lead to criticism that Wall Street is taking its junk to the Fed for cash. Still, he noted that unlike many troubled mortgage securities, there is a discernible market for leveraged loans.

"It's a very creative way for investment banks to get liquidity from assets that they don't want to sell at fire-sale prices," said Todd Kesselman, managing director of Precision Capital, an investment-advisory firm that specializes in structured credit and private equity. The following is an ingenious common sense answer from an anonymous trader: quoted by Hank Greenberg :

I think calling it “brilliant” is about the most jaded comment I have seen through this entire deleveraging fiasco. That’s like calling it “genius” for a teenager to have his Dad bail him out of jail after a drunk driving arrest by using a bail bondsman who only takes a 10% security deposit.

It used to be that banks were required to consolidate 100% of an issue on the balance sheet even if they held only a small “B” or first loss note. The rationale was that if you held the risk of the pool, even only, say $15 million of a $200 million issue, you had to show the entire balance as assets, because you still held the effective VaR (value at risk) of all of the loans, as nothing changed except your maximum loss, not your maximum probable loss (which is effectively the basis fo all bank risk management).

My point is that in a real world, if Lehman still holds the majority of the risk on balance sheet and merely has a loan against the balance, it doesn’t exactly warm the cockles to think they have somehow turned it into “cash (they) could use to finance its business.”

Like I said — dead end economic policy arbitrage. It’s actually kind of sickening. I wonder if the Fed would like to give me a non-recourse loan so I could go “finance my business” down in Atlantic City at the roulette table. I have a foolproof stochastic VaR model that predicts nothing but red numbers for a long time!

To encourage firms to trade more freely with each other, the Fed has taken a series of unprecedented steps to boost liquidity in the markets, including expanding its direct lending to securities dealers. So far, the Fed's measures have helped alleviate some of the strains in the credit markets.

On a different, but related, note we seem to have Lehman playing hide the sausage with losses.

The most recent 10Q has a realized gain of $695 million in the Corporate Equities line for Level II assets, (see Banks, Brokers, & Bullsh1+ part 1 for bullsh1t updates - I just knew I would get to use this link againCool). Comparing this to prior quarters shows a significant jump, averaging considerably less that $70 million, with the largest being $135 million. This is even more fishy considering equities on a global basis were trending downward for the reporting period at hand. I know that level III is supposed tto represent assets with no observable inputs, but come on now, where were these equities as the global markets sank, Mars? Okay, maybe Pluto since Mars may be a little less hospital to financial entitiy life forms.

We also have gains of approximately $550 million from proprietary investment activity. I read this as benefits from playing with adding assets to level three at values they "think" are higher than last reporting period since there are no observable inputs to tell them otherwise (except for a global drop in fixed income and equity prices - but why let that rain on the parade). We now have a new meaning for the term prop desk.

These unrealized Level III equity asset gains were millions of dollars more than what Lehman reported as pretas income for the quarter. That should scare anybody long in the stock. If it it doesn't make you wet your pants, just remember that they also booked about $600 million in FAS 159 gains to arrive at about a $500 million profit for the quarter. FAS 159 gains are for the most part phantom gains (this was addressed in detail in the Reggie Middleton on the Street's Riskiest Bank - Update, and I will excerpt it llater on in this missive as we illustrate MSs games). Take these two tidbits of data in perspective, and Lehman took a very deep loss last quarter, and rallied hard on the their results, on top of it. I believe they were a good short before the price pop, and they are an even better short with the stock 20% higher. I  may even consider welcoming an SEC investigation against me for shorting the stock. We can open my trading books, research and blogs, and in exchange we can also open Lehmans books to see if my research, observations and assertions had any merit or empirical standing - Uh Oh! Here comes that Jack Nicholson effect again, after all, all we want is the truth. "The TRUTH! The TRUTH! YOU CAN'T HANDLE THE TRUTH!!!" I love that scene...

Lehman and it's MSRs: Multiple Statutory wRightups!

With Bear Stearns gone (Is this the Breaking of the Bear?), Lehman is the undispute king of MBS on the street. They are, as a result of being so involved in the industry, rich in MSRs (it really stands for mortgage servicing rights, I was just being an asshole in the subtitleFoot in mouth, or was I?). Lehman wrote UP the value of these assets. Granted, with the current financing home sales market slowing to a crawl, prepayments have dropped considerably, giving a plausible gain to these rights since they will not be eliminated through loans being retired, but their amortization rates fell below the reduced (by one third) long term assumptions. Thus, they are not only kitchen sinking for this quarter, but this is a) a non-cash gain (yeah, like the level III hide the sausage game and the FAS 159 benefit - so "Where's the cash?"), and b) supposedely a hedge (albeit an imperfect one) against Alt-A impairments - we may see some horrow related to this in the future.

Morgan Stanley guys teasing the Lehman guys - "My sausage is bigger than yours..."

 The Reggie Middleton on the Street's Riskiest Bank - Update piece was posted right before Morgan reported. No need to fret though, there were no surprises and they are still the riskiest bank on the street. I would like to not that many sell side instutions have buys on Lehman and Morgan - some with price targets of $65! Whaaaatttt???!! Methinks someone may be sniffing the ink off of the analyst reports before it dries... Since I am just a neophyte individual investor and blogger, I will try not to be intimidated by the big boys, but I must disagree. Consider me the diminuitive captain contrarian.

In the recent 10Q, Morgan's gains from level III assets were exactly 100% more than the level III asset gains for ALL OF LAST YEAR! This was during the roughest and most illiquid structured product, fixed income, and most volatile equity quarter in recent history, if not ever. Hmmmm! I wonder... Oh yeah, they get to determine the values of level III assets, not the market (Banks, Brokers, & Bullsh1+ part 1) - and did they need to do some constructive determining this quarter. Instead of going into MS assets indepth, I will defer to the full report: Reggie Middleton on the Street's Riskiest Bank - Update, but will point out a few interesting tidbits. The report shows a constant trend of shifting assets from Level II to Level III, presumably as they become impossible to value due to illiquidity, in other words - are worth less - this increase is despite impairments incurred in extant level III assets. It appears that as these assets are shifted from level II to III, they may also be revalued to the upside.

This may look pretty on MS income statements, but from an investor's and an economic perspective, this bodes ill. Even if they did some how trade some of this stuff profitably, much of the gains were in derivatives such as CDS what could have a reversal that would wipe out these phantom gains in the future, reversing to a significant loss. This speculation is unnecessary though, since most of it was not cash or real. I am working on regional bank shorts now, but when I'm finished, I will have my analysits revisit this in detail and I will share my results. MS sports the highest concentration of level III assets to tangible equity of any bank on the street save Bear Stearns, and we all know what I thought would happened to the Bear in January (Is this the Breaking of the Bear?).

Pretty reporting with more input from the public relations and marketing departments than the accountants actually caused Morgan Stanley's price to pop, just like Lehman's. When reality (bullsh1t) hits the fan, they will have that much farther to fall.


FAS 159, translated to mean FSA 101 (Fudging to Save our Asses)

Excerpted from Reggie Middleton on the Street's Riskiest Bank - Update:

Since most of these securities are not traded in the secondary market, it would be difficult for Morgan Stanley to translate these accounting gains into economic gains by purchasing them at a discount to par during a widening credit spreads scenario. To explain in simpler terms, marketable securities can be purchased at a discount to par if credit spreads increase as MS debt is devalued. Thus, theoretically, MS can retire this debt for less than par by purchasing this debt outright in the market, and FAS 159 allows MS to take this spread between market values and par as an accounting profit, presumably to match and offset the logic in forcing companies to market assets to market via FAS 157. In reality, only marketable securities can yield such results in an economic fashion, though companies that would be stressed enough to experience such spreads probably would not be in the condition to retire debt. In Morgan Stanley's case, these spreads represent non-marketable or minimally marketable debt to a great extent - such as bank loans, negotiated or OTC /structured borrowings and deposits. These cannot be purchased at less than par by the borrower, thus any accounting gain had through FAS 159 will lead to phantom economic gains that don't exist in reality. For instance, a $1 billion bank loan will always be a loan for the same principle amount, regardless of MS?s credit spreads, unless the bank itself decides to forgive principal, which is highly unlikely. It should be noted that Lehman Brothers actually experienced an economic loss for the latest quarter of about $100 million, but benefitted by the accounting gain stemming from FAS 159, that led to an accounting profit of approximately $500 million. This profit, which sparked a broker rally, was purely accounting fiction. Similarly, Morgan Stanley (in economic profit, ex. "real" terms) overstated its Q1 '08 profit by approximately 50%. This overstatement apparently induced a similarly rally for the brokers. Quite frankly, we feel the industry as a whole is in a precarious predicament due to dwindling value drivers, a cyclical industry downturn, a credit crisis and a deluge of overvalued, unmarketable and quickly depreciating assets stuck on their balance sheets. Their true economic performance is revealing such, but is masked by clever, yet allowable accounting shenanigans. 

Below are snippets from my proprietary Morgan Stanley model that was designed to illustrate the potential benefits of the use, misuse, and absue of FAS 159. I am currently working on regional bank shorts, but when I am finished I will have my analysts scour the most recent 10Qs for things that I missed and report back.

Morgan Stanley, De-shenaniganed by Reggie Middleton:

  Q1 08 Q2 08E Q3 08E Q4 08E Q1 09E
Benefit From FAS 159 Subtracted from Net Income 547.00 148.72 147.41 87.67 58.14
Adj. Earnings / (loss) applicable to common shareholders 987 -1214.67 -297.04 397.40 -82.57
Adj. EPS              0.97            (1.19)          (0.29)            0.39          (0.08)
Cumulative effect of adoption of the fair value option          
 % of liablities 3.13% 0.88% 0.88% 0.53% 0.35%
Widening of credit spreads  95 bps   25 bps   25 bps   15 bps   10 bps 


 For the fiscal year ended November 30, 2007, the estimated changes in the fair value of the Company’s shortterm and long-term borrowings, including fair value option was elected  that were attributable  to changes in instrument-specific credit spreads  were gains of approximately $840 million

We have computed fair value adjustment relating to Morgan Stanley's liablities under the FAS 159 based on expected movement of spreads. We expect Morgan Stanley to record $383 mn gain for reminder of 2008 and $116 mn for 2009 under FAS 159 due to expected widenind of spreads. In 2010 and 2011, we expect Morgan Stanley to report $290 mn and $118 mn loss under FAS 159 due to spreads compression on its liabilities.

 In 1Q 2008, Morgan Stanley recorded $527 million benefit from the impact of widening credit spreads on firm issued structured notes.

Now, if we take the FAS 159 adjusted income and plug it into a P/E model to run the comps...


    Price Shares o/s   EPS          
        2008 2009 2010   Thomson mean for MS - EPS
Morgan Stanley MS 43.5 1104.6 (0.12) 2.47 5.41 5.65 6.63 7.78  
Bear Stearns BSC 10.7 118 6.48 8.95 9.63   Thomson mean for MS - BVPS
Goldman Sachs GS 176.5 395 16.59 20.70 21.80 33.77 38.76 43.95  
Merrill Lynch MER 45.9 969 3.95 5.73 5.83        
Lehman Brothers LEH 43.3 554 4.88 6.75 7.06        
Company Market Cap
(US$ mn)
    2008E 2009E 2010E            
Morgan Stanley       48,074  NM          17.64        8.04 . 
Bear Stearns         1,266        1.65            1.20        1.11  
Goldman Sachs       69,749      10.64            8.53        8.10      
Merrill Lynch       44,468      11.62            8.01        7.87            
Lehman Brothers       23,991        8.88            6.42        6.14            
Industry Average   8.20 6.04 5.80            
Excluding Bear Sterns   10.38 7.65 7.37            
Current share price 43.5                  
P/E approach                    
P/E           7.65                  
EPS (2009) 2.47                  
Estimated Price         18.87                  
Upside (downside) -56.6%                  

We have excluded Bear Sterns from the peer average owing to the recent liquidity crisis faced by the firm in the repo market.We belive that recent initiatives by Fed to open the discount window to prime brokerages firm will help them manage their short term liquidity and they will be able to avert a similar repo crises. That does not mean that I feel they are out of the water. Another bank very well may fail, as the pop media pieces excerpted above regarding LIBOR clearly indicate that the large money center banks certainly agree with me. The next shoe to drop, IMO is the CDS and counterparty credit arena, where the Fed has much less control. This is in essence what happened to Bear Stearns, but on a smaller scale. I think that once the CDS market (or any other market with lax counterparty credit controls) starts to unravel, all hell will break loose. This is essentially what the Fed was trying to prevent in the rescue of Bear Stearns.

As you can see, my forensically cleansed version of Morgan's valuation is significantly different from both the sell side consensus and the current market. Time will tell if this is the collapsing of the House of Morgan as well.