Using Veritas to Construct the "Per…

29-04-2017 Hits:82092 BoomBustBlog Reggie Middleton

Using Veritas to Construct the "Perfect" Digital Investment Portfolio" & How to Value "Hard to Value" tokens, Pt 1

The golden grail of investing is to find that investable asset that provides the greatest reward with the least risk. Alas, despite how commonsensical that precept seems to be, many...

Read more

The Veritas 2017 Token Offering Summary …

15-04-2017 Hits:77729 BoomBustBlog Reggie Middleton

The Veritas 2017 Token Offering Summary Available For Download and Sharing

The Veritas Offering Summary is now available for download, which packs all the information about Veritas in a single page. A step by step guide to purchasing Veritas can be downloaded here.

Read more

What Happens When the Fund Fee Fight Hit…

10-04-2017 Hits:77299 BoomBustBlog Reggie Middleton

What Happens When the Fund Fee Fight Hits the Blockchain

A hedge fund recently made news by securitizing its LP units as Ethereum-based tokens and selling them as tradeable (thereby liquid) assets. This brings technology to the VC industry that...

Read more

Veritaseum: The ICO That's Ushering in t…

07-04-2017 Hits:82045 BoomBustBlog Reggie Middleton

Veritaseum: The ICO That's Ushering in the Era of P2P Capital Markets

Veritaseum is in the process of building peer-to-peer capital markets that enable financial and value market participants to deal directly with each other on a counterparty risk-free basis in lieu...

Read more

This Is Ground Zero for the 2017 Veritas…

03-04-2017 Hits:78637 BoomBustBlog Reggie Middleton

This Is Ground Zero for the 2017 Veritas Offering. Are You Ready to Get Your Key to the P2P Capital Markets?

This is the link to the Veritas Crowdsale landing page. Here is where you will be able to buy the Veritas ICO when it is launched in mid-April. Below, please...

Read more

What is the Value Proposition For Verita…

01-04-2017 Hits:80931 BoomBustBlog Reggie Middleton

What is the Value Proposition For Veritas, Veritaseum's Software Token?

 A YouTube commenter asked a very good question that we will like to take some time to answer. The question was, verbatim: I've watched your video and gone through the slides. The exchange...

Read more

This Real Estate Bubble, Like Some Relat…

28-03-2017 Hits:47814 BoomBustBlog Reggie Middleton

This Real Estate Bubble, Like Some Relationships, Is Complicated...

CNBC reports US home prices rise 5.9 percent to 31-month high in January according to S&P CoreLogic Case-Shiller. This puts the 20 city index close to an all time high, including...

Read more

Bloomberg Chimes In With My Warnings As …

28-03-2017 Hits:79639 BoomBustBlog Reggie Middleton

Bloomberg Chimes In With My Warnings As Landlords Offer First Time Ever Concessions to Retail Renters

Over the last quarter I've been warning about the significant weakness in retailers and the retail real estate that most occupy (links supplied below). Now, Bloomberg reports: Manhattan Landlords Are Offering...

Read more

Our Apple Analysis This Week - This Comp…

27-03-2017 Hits:79164 BoomBustBlog Reggie Middleton

Our Apple Analysis This Week - This Company Is Not What Most Think It IS

We will releasing our Apple forensic analysis and valuation this week for subscribers (click here to subscribe - lowest tier is the same as a Netflix subscription). As can be...

Read more

The Country's First Newly Elected Lame D…

27-03-2017 Hits:79712 BoomBustBlog Reggie Middleton

The Country's First Newly Elected Lame Duck President Will Cause Massive Reversal Of Speculative Gains

Note: Subscribers should reference  the paywall material here for stocks that should give a good risk/reward scenario for bearish trades. The Trump administration's legislative outlook is effectively a political desert, with...

Read more

Sears Finally Throws In The Towel Exactl…

22-03-2017 Hits:84684 BoomBustBlog Reggie Middleton

Sears Finally Throws In The Towel Exactly When I Predicted "has ‘substantial doubt’ about its future"

My prediction of Sears collapsing once interest rates started ticking upwards was absolutely on point.

Read more

The Transformation of Television in Amer…

21-03-2017 Hits:81636 BoomBustBlog Reggie Middleton

The Transformation of Television in America and Worldwide

TV has changed more in the past 10 years than it has since it's inception nearly 100 years ago This change is profound, and the primary benefactors look and act...

Read more

So, Merrill, who up until recently was the world's largest brokerage firm and investment bank, gets bought by Bank of America on the cheap (or maybe not so cheap considering the quality of its assets). Lehman prepares for a bankruptcy filing by midnight tonight, as its counterparties scramble to cross net trades. For those who don't realize it, those $70 billion or so of assets that allegedly did not have a credible bid, will now be dumped onto the market in a bankruptcy sale. Pundits are crowing that the Fed's credit life-line to Lehman will allow for an orderly liquidiation. Not happening... Lehman couldn't dump these assets as a going concern, so what they hell makes anyone think that a bankrupt Lehman hanging by a government credit line thread (which may not even be available since it may no longer be a going concern) as creditors bark down its throat for payment will have even a comparable time getting anything above a penny a pound for these assets? Boys and girls, the sh1t apparently has hit the fan. I've been working on this for a couple of days, but I'm going to release it early and unfinished since current events have made it even more pertinent and timely. Please excuse gaps in thought and logic since it is an unfinished work.

There has been a lot writing lately about the coming collapse of the shadow banking system in the US, hence the global shadow banking system. In lieu of repeating the arguments which have been made so many times on the web (and in my blog),I will simply link to two of them. First, there's the ever so cheerful Nouriel Roubini, and then this guy who I have never heard of but who appears to mirror my thoughts, and to a lesser extent this FT blog. The issue with the FT blog is not its accuracy, for it is on point, it is just the extent (actually, the lack thereof) of its bearishness. The good professor harps on exposure to real assest, mortgages, etc. combined with asset liability mismatch being the catalyst of the weaker banking players fall. I argure that all of the shadow banking system's universal I bank players are at extreme risk of failing (this was written right before Merrill Lynch agreed to be bought and Lehman prepared their bankruptcy filings - so you see I was right, 3 or the nations 5 top banks went bust or bye-bye in less than 6 months - the other two are on standby). All of the US I banks have asset liability funding mismatches, they all of leveraged exposure to popped bubble assets (real property, mortgage derivatives, leveraged loans, leveraged private equity), and most importantly, they do not report the economic risk assumed in the generation of accounting earnings. This is my argument for the short of Goldman Sachs (see the sidebar for related reading). An accurate reporting of economic risk assumed in profit generation on risk adjusted assets would removed the incentive to play the off balance sheet SIV games that hide the bulk of the surprises for the banking industry. Nobody really knows how much risk was taken to generate the accounting rewards reported quarterly, and no one really knows the quality of the assets "allegedly" being reported on. I know one thing for sure. That quality level is not very high. Then again, we have the CDS dilemma, which I will get into in detail a little.


Is Lehman too big to fail? 

Obviously not. It is failing, isn't it? The question of the day is, "Can it be allowed to fail? Lehman is very closely intertwined with US, UK and Eurozone banks through the CDS network. Either it, or one of the other 4 or 5 "quasi" bank failures coming down the pike will set this powder keg a kindle. Let's take a look-see at exactly what is making these banks go pop.

A comparison of the major US investment banks reveals they are cooking dinner with the same seasonings!

Why did Bear Stearns collapse just a few months ago? Contrary to popular belief, it wasn't liquidiy. Lehman has access to unlimited liquidity trhough tht government lending window. Bear Stearns, like Lehman, like Merrill Lynch, like Washington Mutual, like IndyMac Bank, like Fannie and Freddie Mac, like Goldman and Morgan Stanley, are insolvent - that is what's causing the malaise! A quick (historical - this was drafted in January) Bear Stearns drill down reveals the root cause. Notice the highlights in red representing the similarities among the various banks mentioned below. Keep in mind that the investment banks are basically giant hedge funds (in the guise of proprietary trading desks that include clients subscribers) who gamble their own capital along side that of their clients, with secondary fee-based revenue streams from activities such as M&A, securitization (used to be), and brokerage...

Level 2 and Level 3 Assets – Model Risk run amok!

Model risk, or the risk of the bank living in a spreadsheet in lieu of the market, has already reared its head in the summer of ’07 with the blow up of two of BSC’s hedge funds, which have left them in litigation with their own customers. Basically, many of the assets of the fund were levered highly, and valued based upon modeled cash flows from assets, and not from the actual tradable value of the assets. This is fine, until you need to liquidate by selling assets. As luck would have it, they found no market they felt was acceptable and were forced to mark value down significantly, approaching zero. It has also manifested itself in the announcement that they will be moving at least 7 billion dollars to the level three (the most BullSh1+) category. Bear Stearns has recently announced another hedge fund blow up, which doled out significant losses to investors and is attempting liquidation. For my laymen’s plain English take on level 1, 2, and 3 asset accounting, see the Banks, Brokers and Bullsh|+series (Banks, Brokers, & Bullsh1+ part 1 for model risk,).

Level 3 Assets at 231% of Total Equity; Amongst the Highest on Wall Street

Among the top investment banks, Bear Stearns has one of the highest exposures to the riskier class of assets. The company’s exposure to Level 3 assets further increased by $7 billion to $27 billlion as of 30 November 2007, representing almost 229% of its equity, as compared to 70% for Merrill Lynch for the same period. Bear Stearns also has a $43.6 billion of MBS & ABS inventories of which $15 billion is in the CMBS portfolio. In addition, Bear Stearns is exposed to riskier assets through its arrangements with Special Purpose Investment Vehicles (SIVs) having assets totaling $41 billion, of which $37 billion comprises Mortgage Securitizations.


Considering the assets which makeup the Level 2 and Level 3 assets such as distressed debt, non performing mortgage related assets, MBS, Chapter 13 and credit card receivable which are likely to decline in value, our default probability ranges from 2% to 20% in the base and worst case scenarios. Moreover, considering the addition of $7 billion from level 2 to level 3 assets in 4Q 07, we have conservatively assumed a base case default probability of 2% on the Level 2 assets.


Bear Sterns Companies Inc          
In $ Billion Level 1 Level 2 Level 3 Impact of netting Balance as of August 31 '07
Financial instruments owned, at fair value        
Non-Derivative trading inventory 26.8 85.7 14.6 - 127.2
Derivative trading inventory 2.2 101.3 2.0 (90.9) 14.7
Total FI owned at fair value 29.1 187.1 16.6 (90.9) 141.9
Other Assets 0.7 0.9 3.7   5.3
Total Assets at fair value 29.8 188.0 20.3 (90.9) 147.2
As of November 30,2007          
In $ Billion Level 1 Level 2 Level 3 Impact of netting Total
Total Assets at fair value 29.8 181.0 27.3 (90.9) 147.2
Included in level 3 category are distressed debt, non-performing mortgage-related assets, certain mortgage-backed securities and residual interests, Chapter 13 and other credit card receivables from individuals, and complex and exotic derivative structures including long-dated equity derivatives.  

The company quoted in its 4Q 07 conference call "While we haven’t completed the review for the 10-K disclosure, it is anticipated that the amount of Level 3 assets will increase by approximately $7B when compared to August 31 amounts"

Unique method of hiding risk: Special Purpose Investment Vehicles (SIVs) and other things of Myth and Mysticism

The regular readers of realize that in many financial and/or real asset companies, if you dig past the regularly perused and published financial documents and bother to really look under the hood, you are bound to find things that really contradict what the income statements and balance sheets convey. One of the most glaring examples of this is our forensic analysis of the Lennar, the nation’s largest home builder. As luck had it, they actually forgot to put about 40% of their recourse debt in their financial documents and had it sitting in Joint Ventures, formed as special purpose vehicles off balance sheet. No need to fret, though. We tapped them on the shoulder and reminded them of the few billion dollars of liability that they misplaced, ala Enron from the 90’s.

This funny money style of bookkeeping is known as Voodoo Accounting - Any form of accounting that does not follow principles of conservatism. While there are many methods by which financial statements can be fudged, it always comes down to inflating revenue or hiding expenses. Any method that boosts profitability through accounting tricks eventually catches up with the company. As soon as it does "poof", past profits disappear like magic (hence the name "voodoo accounting").

In the investment banking industry, Voodoo magic take the form of VIEs, variable interest entities. For those who actually have a life and don’t spend all of their time reading the fine print of SEC and GAAP reports, VIEs are special purpose (single purpose shell) companies that have one or both of the following characteristics:

1. The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity.

2. The equity investors lack one or more of the following essential characteristics of a controlling financial interest:

a. The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights

b. The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities

c. The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses.

So, if I may take license to grossly oversimplify this subject, this is what the I-banks use to put assets and liabilities off the books, thus giving the appearance of a higher ROI/ROA (since the ”I” [investment] and the “A” [assets] are not readily discernable on the books (at least for a simple man such as myself), but the “R” [return] is). Now, if you glance at the VIE chart below, you can see that the VIE assets are not exactly Treasury Bills and cash equivalents:

· Energy assets – can get pretty esoteric and are definitely not straightforward to value and trade,

· CDO’s/CLO’s – these have been in the popular media enough where I don’t need to explain,

· distressed debt – risk aversion has caused spreads to widen significantly (actually, they’re just reverting back to mean) leaving those who bought on narrow spreads holding the bag,

· and mortgage securities – need I say more...


This stuff is:

1. Illiquid and hard to trade;

2. Not very transparent price wise and subject to EXTREME model risk, and;

3. Three out of four of the bullet list are considered toxic sludge by today’s market, which is trending down in liquidity and up in risk aversion.

Far be it for me to proclaim myself the grand arbiter of all things fair and equal, but it damn sure seems like cheating to me if a company is allowed to stuff these things away off balance sheet. Since everyone doesn’t read my blog, and most other people have a life, how in the world would the average retail or even professional investor know that these exist, where to look for them, how to value them, and how to adjust for and quantify risk. The company definitely wasn’t very forthcoming. I will send them a copy of this blog post and ask for further clarification.

In my Voodoo piece on Lennar as well as the very definition of Voodoo accounting itself, it is made it clear that shenanigans like this often come back to haunt the companies that play them, ala Enron. Well, investment banks are no exception. The value of the assets in the Bear Stearns VIEs have decreased by 18%, but the maximum exposure to risk from these entities has actually increased by 16.5%. The increase is in both absolute terms and in proportion to the VIE assets. Uh, Oh!!! I shouldn’t have to remind my astute readers that, CNBC perma-bulls aside, the macro environment that spawned that 18% loss in the VIEs is not only still here but getting significantly worse, and on a global scale. Simply glance at the residential and commercial graphs above, or the global risk asset sell offs of the recent weeks as a reminder.



Bear Stearns also owns significant variable interests in several VIEs related to CDOs & CLOs for which the company is not the primary beneficiary and therefore does not consolidate these entities into its books. In aggregate, these VIEs had assets of approximately $21.3 billion and $14.8 billion as of August 31, 2007 and November 30, 2006, respectively. On August 31, 2007 Bear Stearns estimated maximum exposure to loss from these entities to approximately $194.0 million.

Counterparty Risk

In $ million   OTC Derivative credit exposure ($ million)      
The table summarizes the counterparty credit quality of the company's exposure with respect to OTC derivatives  
Rating(2) Exposure Collateral (3) Exposure, Net of Collateral (4) Percentage of Exposure, Net of Collateral Total exposure a % of Total assets Net exposure as a % of Total assets Net exposure as a % of equity
AAA 3,369 56 3,333 42% 0.8% 0.8% 25.6%
AA 6,981 4,939 2,153 27% 1.8% 0.5% 16.6%
A 3,869 2,230 1,784 23% 1.0% 0.4% 13.7%
BBB 354 239 203 3% 0.1% 0.1% 1.6%
BB and lower 1,571 3,162 322 4% 0.4% 0.1% 2.5%
Non-rated 152 223 94 1% 0.0% 0.0% 0.7%
  16,296 10,849 7,889 100% 4.1% 2.0% 60.7%
(1) Excluded are covered transactions structured to ensure that the market values of collateral will at all times equal or exceed the
related exposures. The net exposure for these transactions will, under all circumstances, be zero.    
(2) Internal counterparty credit ratings, as assigned by the Company’s Credit Department, converted to rating agency equivalents. (3) Includes foreign exchange and forward-settling mortgage transactions) as of August 31, 2007

Now, let's compare and contrast Bear Stearns (pre-blowup) and Lehman to Morgan Stanley

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan Stanley’s level 3 asset exposure, which stood at 261% of its equity as of February 29, 2008, is likely to cause a significant drag on its valuation in the near future. These assets, for which the bank uses proprietary models to gauge their value, will witness the largest write-downs of all asset categories amid the current credit market turmoil. When compared with other leading investment banks, Morgan Stanley clearly stands out to be the most vulnerable to falling values in these hard-to-value assets. It is worthwhile to mention that Bear Stearns, which last month witnessed significant erosion in its market capitalization, had level 3 assets equal to 239% of its equity, next only to Morgan Stanley. Although the Fed has mitigated liquidity concerns of investment banks in significant part, the balance sheet solvency is a far more difficult problem to address – and one in which Morgan Stanley leads the pack. 
Bank Level 1 Assets Level 2 Assets Level 3 Assets Shareholder Equity Total Assets Level 1 Assets-to-Total Assets Level 2 Assets-to-Equity Level 3 Assets-to-Equity Leverage (X)
Citigroup $223 $934 $133 $114 $2,183 10.2% 822% 117% 19.21
Merrill Lynch $122 $768 $41 $32 $1,020 12.0% 2405% 130% 31.94
Lehman Brothers $73 $177 $39 $26 $786 9.2% 687% 152% 30.59
Goldman Sachs $122 $277 $72 $47 $1,120 10.9% 586% 153% 23.71
Morgan Stanley $115 $226 $74 $31 $1,045 11.0% 723% 236% 33.43
Bear Stearns $29 227 $28 $12 $96 30.7% 1926% 239% 8.15
Based on latest quarterly filings and transcripts 
Also, the growing proportion of level 3 assets in Morgan Stanley’s total asset exposure is raising investors’ concerns over expected write downs in the coming quarters. The bank’s level 3 assets have increased partly due to re-classification of assets from level 2 to level 3 on account of unobservable inputs for the fair value measurement. During 4Q2007, Morgan Stanley re-classified $7.0 bn of funded assets and $279 mn of net derivative contracts from level 2 to level 3. Morgan Stanley’s level 2 assets-to-total assets ratio declined to 5.2% in 4Q2007 from 8.9% in 1Q2007 while its level 3 assets-to-total assets increased to 7.0% in 4Q2007 from 4.3% in 1Q2007 indicating growing uncertainty associated with valuation of assets not readily marketable. The trend can be expected to continue in the coming quarters as uncertainty associated with realizing values from illiquid assets continues to grow.  
High leveraging could hinder capital raising abilities: While expected asset write-downs could continue eroding Morgan Stanley’s equity at least for the next few quarters, the company’s higher-than-peers leverage levels could prove to be an impediment in raising additional capital to maintain its statutory capital levels. Morgan Stanley’s leverage (computed as total tangible assets over tangible shareholders’ equity) stood at 37.3X as of February 29, 2008, while the bank’s balance sheet size had been reduced to $1,091 bn as of that date from $1,182 bn on November 30, 2007. The bank’s leverage is the highest among its peers which could be a cause of concern amid falling income levels and tight liquidity conditions in the financial markets.
 * Adjusted assets / adjusted shareholder's equity 
Morgan Stanley taking initiatives to “de-risk” its balance sheet: In the wake of issues underpinning the current crisis in the markets, Morgan Stanley is making continued efforts to “de-risk” its balance sheet by reducing its exposure to risky credit positions. Morgan Stanley’s total non-investment grade loans decreased to $26 bn in 1Q2008 from $30.9 bn in 4Q2007. In addition Morgan Stanley reduced its gross exposure towards CMBS and RMBS securities to $23.5 bn and $14.5 bn, respectively, in 1Q2008 from $31.5 bn and $16.5 bn, respectively, in 4Q2007. {mospagebreak}

Worsening credit market to impact Morgan Stanley’s financial position

The current gridlock in the credit market has drastically pulled down the mark-to-market valuation of mortgage-backed structured finance products, resulting in significant asset write-downs of banks and financial institutions. It is estimated that further write-downs by investment banks could touch $75 bn in 2008 after an estimated $230 bn already written off since the start of 2007. With the situation not expected to improve in the near-to-medium term, investment banks are likely to face a sizeable erosion of their equity from large write-downs in the coming periods. Though the recent mark-down revelations by UBS and Deutsche Bank have injected some positive sentiment in the global capital markets with the hope that the credit crisis has reached an inflection point, it is overly optimistic to believe that the beginning of the end of the current turmoil is at hand before the causes of the turmoil, tumbling real asset prices and spiking credit defaults, cease to act as catalysts.
* expected 
Morgan Stanley wrote off a significant $9.4 bn of its assets in 4Q2007. However, the write down in 1Q2008 was much lower with $1.2 bn mortgage related write-down and $1.1 bn leveraged loan write-down, partly offset by $0.80 bn gains from credit widening under FAS159 adjustments. One of the factors which the bank considers while estimating asset write-downs is the movement in the ABX index which tracks different tranches of CDS based on subprime backed securities. Nearly all tranches of ABX index have witnessed a significant decline over the last six months. While Morgan Stanley’s 4Q2007 write-down of $9.4 bn appeared in line with a considerable fall in the ABX index during the quarter, a similar nexus is not evident for 1Q2008. Morgan Stanley recorded a gross write-down of $2.3 bn in 1Q2008 though the decline in ABX indices seemed relatively severe (however not as steep as in the preceding quarter). The disparity raises a concern that Morgan Stanley might report more losses in the coming periods. 
ABX BBB indices (September 26, 2007, to  April 2, 2008) Source: Marki.comt Although the ABX indices showed a slight recovery in March 2008, this is expected to be a temporary turnaround before the indices resume their downward movement owing to expected continuing deterioration in the US housing sector and mortgage markets. The following is a detailed, yet not exhaustive, example of Morgan Stanley's "hedged" ABS portfolio - icon Morgan Stanley ABS Inventory (1.65 MB).
"Hedged" is a parenthetical because we believe that large scale investment bank hedges are far from perfect. We discuss this later on in the report.
The US housing markets are yet to stabilize and housing prices are still above their long-term historical median levels, leaving scope for a further downside in prices. Between October 2007 and January 2008, the S&P Case Shiller index declined nearly 6.5% (with 2.3% decline in January 2008 alone). We would like to make it clear that although the CS index is an econometric marvel, it does not remotely capture the entire universe of depreciating housing assets. It purposely excludes those sectors of the housing market that are hardest hit by declines, namely: new construction (ex. home builder finished inventory), condos and co-ops, investor properties and “flips”, multi-family properties, and portable homes (ex. trailers). Investor properties and condos lead the way in defaults due to excess speculation while new construction faces the largest discounts, second only to possibly repossessed homes such as REOs. A decline in this expanded definition of housing stock’s pricing could result in increased defaults and delinquencies, significantly beyond that which is represented by the Case Shiller index, which itself portends dire consequences. As credit spreads continue to widen over the next few quarters, the assets would need to be devalued in line with risk re-pricing. Morgan Stanley and the financial sector in general, are expected to continue with their balance sheet cleansing exercise, recording further asset write-downs till stability is restored in the financial markets.  While it is believe the expected continuing fall in the security market values would

Hey, look at the red highlight. We've hear this story before through Lehman's filings!

Lehman has benefited the most on a relative and absolute basis thus far from FAS 159 accounting. Since they've filed their 10K recently we can update the total benefit they've booked as a result of a decline in their own credit worthiness for the liabilities they've elected to measure at fair value (FAS 159 allows companies to apply fair value to both their assets and LIABILITIES). From the 10K, on page 109 it states that "The estimated changes in the fair value of these liabilities were gains of approximately $1.3 billion, attributable to the widening of our credit spreads during fiscal year 2007." Lehman appears to have used $900 million of this gain to decrease the impact of write-downs (see table on page 49 of the LEH 10K, under "Valuation of debt liabilities"). For the year, Lehmam booked write-downs of $1.9 billion total, however backing out FAS 159 gains would have substantially increased this amount.

indicate more write-downs in the coming quarters, a part of this could be set-off under FAS159 by implied gains from write-down of financial liabilities off an expected widening of credit spreads. Morgan Stanley is expected to record assets write-down losses of $16.5 bn and $7.6 bn in 2008 and 2009, respectively, considering the bank’s increasing proportion of level 3 assets amid falling security values. This would be partially off-set by FAS159 gains of $930.8 mn and$116.1 mn in the two years off revaluation of its financial liabilities. It is important to note the fact that FAS 159 gains are primarily accounting gains, and not economic gains and they do not truly reflect the economic condition of Morgan Stanley. Of the $18.3 bn of total liabilities for which the bank makes adjustments relating to FAS159, $14.2 bn and $3.1 bn of liabilities relate to long-term borrowings and deposits.
Since most of these securities are 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 debt such as bank loans, negotiated 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 $500 million. This profit, which sparked a broker rally, was purely accounting fiction. Similarly, Morgan Stanley (in economic profit, ex. “real” terms) overstated its Q1 ’08 profit by approximately 50%. This overstatement apparently induced a similarly rally for the brokers. Quite frankly, we feel the industry as a whole is in a precarious predicament due to dwindling value drivers, a cyclical industry downturn, a credit crisis and a deluge of overvalued, unmarketable and quickly depreciating assets stuck on their balance sheets. Their true economic performance is revealing such, but is masked by clever, yet allowable accounting shenanigans.
Morgan Stanley Write-down -2008 Level 1 Level 2 Level 3   Total
(In US$ mn)          
Financial instruments owned          
U.S. government and agency securities                -                 12                 2                 14
Other sovereign government obligations                -                   9                 0                   9
Corporate and other debt                 2          2,761          2,223  Stuck with bad leveraged loans and debt          4,986
Corporate equities             413               71               62               546
Derivative contracts             226          7,252          3,240  CDS anyone???
Investments                 1                 1             196  Nearly 98% of their investments are illiquid!             198
Physical commodities                -                 12                -                   12
Total financial instruments owned            642       10,120         5,723         16,485

Significant counter-party risks from monoline downgrades to result in further write-downs

While hedging does function as an effective tool in minimizing loses from write-downs of dubious assets, hedging in the form of protection from monolines/bond insurers carries associated counterparty credit risks which cannot be ignored in the current environment of continued weakening of monolines. An increasing probability of counterparty risks materializing for investment banks from the deteriorating financial position of the monolines could contribute to further asset write-downs by the banks. It is estimated that the top five US investment-banks have a combined $23 bn in uncollateralized exposures to triple-A rated counterparties part of which is with the monocline bond insurers including AMBAC, MBIA (may face downgrade from Fitch, same with Ambac), and FGIC (is now rated as junk), which have been a subject of downgrades in the last few months. Merrill Lynch’s total uncollateralized exposure to triple-A counterparties stood at $7.1 bn as of August 31, 2007, while that of Morgan Stanley was $7 bn as of that date. The corresponding figures for GS, Lehman and Bear Sterns were $4.7 bn, $4 bn and $330 mn, respectively. Merrill Lynch has reported that around 50% of its total hedging is in the form of monoline insurance, giving a fair indication of the possible write-downs resulting from downgrades of monolines. Merrill Lynch also reported a $3.1 bn asset write-down in 4QFY07 in response to a downgrade of ACA Capital (to which it had an exposure) to junk status.
As of February 29, 2008, Morgan Stanley had $4.7 bn aggregate exposure towards monolines with a $1.3 bn exposure in ABS bonds, $2.6 bn in municipal bond securities and $0.8 bn in net counter party exposure. The deterioration of credit market coupled with significant losses suffered by monolines had caused downgrades of monolines. Any further downgrades of monolines could result in additional write-downs by financial institutions and adversely affect the financial markets. Morgan Stanley recorded approximately $600 mn write-down in 1Q2008 on account of its exposure from monolines. S&P estimates that the total hedges to CDO exposures by bond insurers are currently around $125 bn, though the location of these hedges is not entirely known. A separate report by Oppenheimer & Co estimates that the total write-down by the financial institutions resulting from potential rating downgrades of monolines could range between $40 bn to as high as $70 bn, with Citigroup, ML, and UBS being the most vulnerable as they together hold a large chunk of the credit market risk associated with bond insurers. The coming quarters could thus witness more significant assets write-downs if monolines are downgraded.
The possible relief comes from the recent developments whereby monolines have been successful in raising capital to maintain their AAA ratings.  Earlier, in March 2008, both S&P and Moody’s affirmed AAA and Aaa ratings, respectively, to AMBAC after it raised $1.5 bn through sale of common stock and convertible units.  Another factor which may reinforce the banks’ counter party risks on monocline exposure are the recent developments which indicate that the monolines may be looking for means to terminate their guarantee contracts with the banks to evade their liabilities. A case in point is the legal battle initiated between Merrill Lynch and Security Capital Assurance (SCA) wherein Merrill Lynch sued SCA’s XL Capital Assurance unit on the ground that the latter refused to honor the commitments arising on the bank’s CDS worth $3.1 bn. SCA has in turn alleged that Merrill Lynch had not honored the contractual terms by transferring the control rights on the CDOs to a third party. More such legal battles could follow creating increased uncertainty on the true extent of hedging exercisable on monocline exposure. {mospagebreak}

Hidden losses from unconsolidated VIE’s a cause of concern for Morgan Stanley

Morgan Stanley has a significant exposure to MBS, ABS, credit and real estate assets and other structured transactions through VIEs. As at November 30, 2007 Morgan Stanley consolidated $22.4 bn of assets from VIEs, with a maximum loss exposure of $17.6 bn. In addition, the bank also has $37.7 bn in exposure through unconsolidated VIEs with a maximum loss exposure of $15.9 bn, yielding a maximum loss-to-total exposure at 42.4%. Morgan Stanley’s total exposure towards unconsolidated VIEs is in some of the riskiest asset class categories, including a $7.2 bn exposure towards MBS and ABS securities (maximum loss-to-exposure of 3.9%), $20.3 bn towards credit and real estate (maximum loss-to-exposure of 65.4%) and $10.2 bn towards structured transactions (maximum loss-to-exposure of 23.9%).   
 $22 Billion dollars of "who the hell knows what!" is tucked away in "who the hell knows where!". Just like Lehman, Bear Stearns, Merrill and Goldman!
Consolidated VIE's  ($ mn) 30-Nov-07
US$ mn VIE assets consolidated  Maximum exposure to loss
 Mortgage and asset-backed securitizations 5,916 1,750
 Municipal bond trusts 828 828
 Credit and real estate 5,130 5,835
 Commodities financing 1,170 328
 Structured transactions (what the hell is this?) 9,403 8,877
 Total 22,447 17,618
   This is almost the entire off balance sheet asset base!Theymight as well say just about all of it. 
Unconsolidated VIE's ($ mn) 30-Nov-07
US$ mn VIE assets not consolidated Maximum exposure to loss
 Mortgage and asset-backed securitizations 7,234 280
 Credit and real estate 20,265 13,255
 Structured transactions 10,218 2,441
 Total 37,717 15,976
 When it's off balance sheet (ex. off the record) we really don't know how accurate these numbers are, now do we???
As can be ascertained from its high maximum loss-to-exposure ratio of 65.4%, the credit and real estate product is the most vulnerable of all the products in respect of a probability of defaults considering that most of the US housing problem is linked to loans originated with poor underwriting standards to marginal buyers at the peak of the housing bubble. Falling housing prices coupled with stringent lending standards are making it increasingly difficult for borrowers to refinance existing loans resulting in higher delinquency and foreclosures for these loans. Under our base case scenario we have estimated total losses of $4.2 bn from unconsolidated VIEs primarily off losses from the credit and real estate sectors. Also it is worth mentioning that some investment baking firms (prominently UBS and Lehman) are spinning off or considering a spinoff of their riskier assets into separate subsidiaries, CLOs and SIVs as an off-balance sheet exposure in an attempt to shrink their balance sheet through accounting shenanigans designed to deceive investors by presenting a rosy picture of their financial affairs.

Despite Fed’s initiatives, liquidity concerns remain persist

Drying liquidity in the repo market: The rapid contraction of liquidity in the $4.5 trillion repo market, comprising 20-25% of the total assets of the top five investment banks, is posing a difficult and challenging operating environment for these companies. With a declining value of securities used as collateral, lenders in repo markets have tightened their lending standards, besides being over-cautious and selective. In addition, they are also demanding higher collateral. For instance, for every $100 to be lent, lenders require $105 for bonds backed by Fannie Mae and Freddie Mac (up from $102 a few weeks ago) and $130 for bonds backed by 'Alt-A' loans. Last month, Bear Stearns faced a severe liquidity problem before it sought an emergency funding from the Federal Reserve, as its clients withdrew assets while their creditors stopped renewing short-term loans. The financing crisis at Bear Stearns has created wide spread concerns over the financial stability of other brokerage firms which rely heavily on repo markets for day-to-day cash requirements.
 Like Bear Sterns, Morgan Stanley also relies on short-term financing with $162.8 bn or 16% of its total assets in the form of repo financing as of November 30, 2007. Traditionally, brokerage firms have borrowed money in the repo market to fund their short-to-medium-term financing needs. Now with credit being harder to come by in spite of falling interest rates, brokerage firms will operate at lower leverage levels (total adjusted assets to adjusted equity), thus impacting their future profitability. 
Signs of reduced liquidity also emerged when Morgan Stanley found it difficult to renew its credit line to back up its commercial paper, and had to accept a reduced credit line. Instead of seeking to extend the entire $11 bn line, Morgan Stanley originally sought a $7.5 bn credit line. However, banks were willing to extend only under $4.9 bn. 
Although the recent Fed-led initiatives will help banks and brokerages temporarily swap their mortgage-backed securities for treasury debt and restore some liquidity, the problem is far from being solved with additional losses from write-downs expected in 2008 and 2009. We have alleged that the Fed’s liquidity injections address and mitigate, in large part, the symptoms of the problem that formed the credit crisis but fail to address the cause – which is balance sheet insolvency. This, unfortunately, is beyond the reach of even the Fed’s many economic tools, and the only way for it to be remedied is to allow the assets to properly deflate and be redistributed throughout the market at market prices. We have witnessed significant resistance to this event, for if many of the investment, regional, mortgage and commercial were to truly mark their inventory to market, rampant insolvencies would result. We believe the Fed’s attempts at injecting liquidity are ploys to buy time for the lending and financial engineering institutions to delever and redistribute risk and assets at a controlled pace. The major problem with this tactic is that since the assets were written at the top of an historical real asset bubble that just popped, and were levered at the top of a historic credit bubble that just popped, there is absolutely no market for these securities for anything remotely near a price that would allow the lending and financial engineering agencies to remain fully solvent. This is not to say that they will all go the way of Bear Stearns, but we do believe that there is a lot of pain ahead as these entities attempt to delever, shrink their balance sheet and reduce risk. In addition, there is a significant probability of another institution going belly up. 

Now, let's take a look at Goldman Sachs!

No real difference in their business model outlook and asset liability situation. Don't believe me??? Have taken a close look lately or just took the media and your local analyst's word for it?

High financial risk reflected by adjusted leverage ratio: GS scores relatively low among its peers in terms of the adjusted leverage ratios, representing higher financial risk. Although the second quarter saw a noticeable fall in GS' adjusted leverage ratio to 14.7x from 18.6x in 1Q2008, following a $100 bn trim down in total assets, the ratio still remains higher than those of its peers.  

Massive off-balance sheet exposure of probable losses from unconsolidated Variable Interest Entities (VIEs): With GS' maximum exposure to loss in unconsolidated VIEs standing at $22.2 billion, representing nearly 50% of the total shareholder's equity, compared to similar figures of 26% and 4% for Morgan Stanley and ML, respectively, GS assumes a far higher off-balance sheet risk. Further, the exposure is in some of the riskier and troubled asset categories like CDOs, CLOs and real estate securities, held indirectly through its unconsolidated VIEs, which is likely to dent GS' performance in coming periods. Keep in mind that since this stuff is hidden off balance and as level 3, GS can consistently put out relatively good accounting numbers while taken a severe drubbing economically. Don't believe me? Ask the BSC and LEH equity investors the difference between their share price last year and today, with no real sign from accounting earnings until a couple of quarters ago.


Illiquid level 3 assets forming a relatively higher proportion of adjusted total assets: With a relatively high level of level 3 assets as percentage of total assets and as percentage of shareholders' equity compared to its peers, GS could run risk of higher write downs, particularly on mortgage backed securities, as spread continue to widen and investors appetite for risk continue to decline. Although these ratios witnessed a decline in the second quarter of 2008 due to transfers to level 2 assets, GS continue to have sizeable exposure in high risk Alt-A and subprime residential mortgage-backed securities.


Tough times anticipated in GS core businesses: GS' core businesses are likely to get hit by continuing global slowdown in the capital market activities. Slackening M&A, IPO and bond issuance activities are likely to impact the investment banking revenues while lower investors' risk appetite and continuing negative returns in equities will probably slow-down GS' trading and fee-based asset management income, in our view. The exception to this would be those proprietary and client driven volatility trading desks that attempt and may succeed at benefitting from extremes in volatility. This is a dual edged blade though, for these trading strategies often carry higher inherent risks, higher VaR, and lower risk adjusted returns than the more plain vanilla businesses. Basically, when the doo doo hits the fan in these businesses, it tends to splatter farther than normal - splashing any business units that may be standing around.


GS' asset quality has declined over the past two quarters: The proportion of non-investment grade securities in GS' trading and investment portfolio has increased over the last two quarters. Though GS' liquidity position remains strong, exposure to riskier assets raises concerns about write downs in the near future. This is expected to be exacerbated in the very near future due to the fact that there are no longer any insurers who have, and who are wrapping derivative securities that have a AAA or Aaa rating that is not on negative watch for prospective downgrade. This translates into a literal dearth of high end investment grade derivative instruments that relied on monoline insurance wraps. It also means that the implicit leverage inherent in overcollateralization (a method of pursuing a higher credit rating for security by pledging more than 100% collateral to a deal) may very well come home to roost in unexpected ways.



The Wall Street Journal ran an interesting article today:

Barclays Emerges as a Leader In Talks Over Lehman Brothers


A sale of Lehman to either Barclays or Bank of America Corp. remained dependent on government financial support, according to people familiar with the situation. According to these people, Barclays appeared to be moving more aggressively in trying to find a way to complete a deal.

That, however, would put any proposed deal at odds with the government's reluctance to step in with funding. We shall see. A dangerous precedent has been set with the Bear Stearns bailout.

... Under a plan that was crystallizing Sunday, either Barclays PLC or Bank of America Corp. would buy Lehman's "good assets", such as its equities business, people familiar with the matter say. Lehman's more toxic, real-estate assets would be ring-fenced into a "bad" bank that would contain about $85 billion in souring assets. The move would avert a flood of bad assets deluging the market, damaging the value of similar assets held by other banks and insurers. This is only from an accounting perspective. If the market (guys like me) have any idea of what was in the bad bank, the mere fact that it was in the bad bank devalues like and similar assets. Who the hell do they think they're fooling. It is this paper shuffling, shell game mentality that got them into this situation to begin with! On Saturday, one idea was for Wall Street firms to inject some capital into the bad bank. By Sunday morning, though, this option appeared to be losing support. Unlike when Wall Street firms stepped in to bail out hedge fund Long-Term Capital Management, today's banks are much weaker financially. Some also are loathe to provide financial support at the same time a rival like Barclays has the potential to buy Lehman for a cheap price...

On Saturday afternoon, the credit-trading heads of major investment banks gathered at the meeting to discuss how to deal with their exposures to Lehman in the intertwined credit-default-swap market. The lack of a central clearinghouse in this market means that dealers, hedge funds and others are directly facing each other in insurance-like contracts that are tied to trillions of dollars in debt instruments.

Credit derivative traders at some firms were asked to come to work over the weekend to help quantify their exposures to Lehman and compile lists of outstanding contracts they have with the investment bank.

One person familiar with the matter said large dealers contemplated showing each other all of their credit default swap trades with Lehman. Disclosing their positions may enable dealers to find ways to offset their positions with each other wherever possible. Later in the day, some traders were told that Lehman -- with the help of Federal Reserve officials -- will try to figure out which of its counterparties have CDS trades that can be offset. Those counterparties would be informed of the offsetting positions, following which they can unwind their respective swaps with Lehman and concurrently enter into new swap contracts with each other. For example, if one dealer has bought a swap from Lehman and Lehman sold a similar swap to another bank, the two banks could agree to face each other directly. I am going to go over Lehman's CDS risk to the world in full detail in the second half of this missive.

Such moves could help prevent individual firms from scrambling to find new counterparties to rehedge their positions with when the markets reopen on Monday, potentially unleashing turmoil across the credit markets. They could also help facilitate an orderly wind-down of Lehman's derivative positions, if that becomes necessary. Still, sorting out the firm's CDS positions promises to be a difficult and time-consuming task, because many of the contracts have different terms and maturity dates.

It is not known how much in CDS contracts Lehman has. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied.

Wall Street traders poured into their offices Saturday for emergency meetings to consider the actions they would take if Lehman is forced into liquidation. They broke into teams to evaluate their positions and exposure to Lehman in everything from energy trades to equity derivatives to credit,

One trader said conditions in the credit default swap market and the short-term repo markets are more stable today than they were in March, when Bear Stearns nearly collapsed, but still, "if they go into liquidation," it is going to be a bad situation on Monday.

A disorderly unwind of Lehman's derivatives trades is only one worry. Another worry is that if Lehman collapses, its distressed assets -- such as commercial real estate -- could suddenly hit Wall Street for sale, forcing prices even lower and potentially forcing other dealers to mark down once again the value of their own holdings.

Well, since working on this section of the article this morning, Barclays has pulled out of the deal and Lehman is preparing to flle for Bankruptcy.


About those CDS

The CDS insurance contract created primarily to transfer credit risk from bond investors to other parties may be insurance companies or hedge funds to protect against the default risk. However, as depicted in the chart below, the financial institutions may sell and resell the insurance contracts among themselves creating the ‘entanglement of credit risk’. This also makes it difficult to identify who bears the ultimate risk. This reselling of insurance contacts to another party has created a near untraceable credit risk web among the market participants.


Source: The New York Times

  Single name CDS’ total notional amount outstanding has increased from US$7.31 trillion in June 2005 to US$24.2 trillion in June 2007 while the multi name CDS has grown from US$2.9 trillion in June 2005 to US$18.3 trillion in June 2007.



Source: Thomson Research


The CDS market has outstripped the growth in every other US market reaching US$45 trillion in notional amount outstanding volume. According to ISDA, the notional amount outstanding of credit derivatives grew 32% in the first six months of 2007 to $45.46 trillion from $34.42 trillion. The annual growth rate for credit derivatives is 75% from $26.0 trillion at mid-year 2006 surpassing the US stock markets at US$21.9 trillion, the mortgage security market at US$7.1 trillion and the US treasuries market at US$4.4 trillion. The ability to bet on the financial health of the company directly in the CDS market (go long or short by buying or selling insurance protection) and the rise in speculative interest saw the rise in the CDS volumes.

 Related Reading

Reggie Middleton says the CDS market represents a "Clear and Present Danger"!

Would Lehman’s Default Be a Systemic CDS Event? by Elisa Parisi-Capone

Is this the Breaking of the Bear? 

 Bear Fight - A most bearish view on Bear Stearns in a bear market

The Riskiest Bank on the Street 

Reggie Middleton on the Street's Riskiest Bank - Update 

Market missing the missiles aimed at Morgan Stanley??? 

Quick Morgan Stanley update from my lab 

Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis and Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street.

The media and retail investors are now realizing that I banks are really publicly traded hedge funds 

Banks, Brokers, & Bullsh1+ part 1 

Banks, Brokers, & Bullsh1+ part 2 

Dangerously Close to a Money Panic by Martin D. Weiss Ph.D. 

Hey guys, we saw this coming!

According to the Bank for International Settlement (BIS), North American investment banks reported significant surge in spreads from 50 basis points in July 2007 to a temporary peak of 100 basis points in August 2007 and then to 140 basis points in January 2008. In addition, the North American commercial banks and European universal banks witnessed surge in the CDS spreads. The increased level of CDS spreads coupled with increased co-movement implies that the market perceives a greater likelihood of joint defaults and, thus, higher systemic risk.



Role of financial guarantors in the CDS market

In the CDS market, the role of bond insurers needs to be clearly understood as they play multiple roles including that of the counterparty (the seller of protection) and as reference entity (on whom the CDS insurance contract has been created). There also needs to be a demarcation of financial guarantor holding companies and the regulated operating insurance entity as the financial guarantor. In case of a negative assessment of the financial guarantor counterparty risk (as a seller of protection), it could potentially result in a significant reversal of mark-to-market gains for those counterparties that purchased protection from these financial guarantors. The financial guarantors have provided credit protection to the stressed asset categories such as the subprime structured collateralized debt obligations (CDOs) and other structured finance products. Therefore, if a financial guarantor fails, the counterparties will suffer - we have a making of the very same type of systemic crisis that was allegedly averted with the Federal Reserve bailout of Bear Stearns – and quite possibly and a considerably larger level.


For those who are not regulars to my, we have provided deep dive analyses of the major monolines, warning of their insolvency and downfall last year - well in advance of their share price downfalls. See:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billi
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses through credit markets


In addition, CDS contracts have been written on financial guarantors specifically as the reference entity, on both the financial guarantor holding company as well as the operating company. It is likely that a large amount of protection has been written on both entities to possibly offset the counterparty risk or merely for the purpose of naked speculation. According to the Fitch Synthetic CDO Index, on a cumulative basis, six of the top 25 entities referenced by Fitch-rated synthetic CDOs have been either the financial guarantors or their parents as of 2006. In the case of CDS written on the financial guarantors, the market theoretically could face certain unique settlement issues should a credit event occur. Any potential crumbling of the financial guarantor could have significant impact for both the CDS in which the financial guarantor is the counterparty, and CDS in which the guarantor is the reference entity. Consequently, it will also affect the counterparties such as the broker dealers and various banks to revalue their positions and offsetting hedges.

This brings us to a interesting inflection point. Lehman has hidden their losses through FAS 159 accounting and the Level 2 to 3 shell game. This helped them some, but the majority of their asset devaluation protection came from very large hedges. Can you take a gander where these hedges came from? That's right, CDS contracts, probably written by you know who.

Let's reference an email sent to me back in February (when Lehman was trading just under $60) regarding Lehman's Lemming Shenanigans:

"I think Lehman may be an interesting bank to look into (even though I believe Bear Stearns is in the absolute worst position, Lehman is not much better off I think, while at the same time being perceived as having dodged excessive write-downs a-la Goldman Sachs). It starts with FAS 159 which you may be aware of. You can read how this has helped out the investment banks in the link below.

Lehman has benefited the most on a relative and absolute basis thus far from FAS 159 accounting. Since they've filed their 10K recently we can update the total benefit they've booked as a result of a decline in their own credit worthiness for the liabilities they've elected to measure at fair value (FAS 159 allows companies to apply fair value to both their assets and LIABILITIES). From the 10K, on page 109 it states that "The estimated changes in the fair value of these liabilities were gains of approximately $1.3 billion, attributable to the widening of our credit spreads during fiscal year 2007." Lehman appears to have used $900 million of this gain to decrease the impact of write-downs (see table on page 49 of the LEH 10K, under "Valuation of debt liabilities"). For the year, Lehman booked write-downs of $1.9 billion total, however backing out FAS 159 gains would have substantially increased this amount. Again, looking at the write-down table on page 49 Lehman describes their gross and net write-down totals. From this we can back into how hedged Lehman is in each category of investment. The two primary categories to look at are there Residential mortgage-related and Commercial mortgage related positions. Looking at Residential, they booked a $4.7 billion gross write-down but only a $1.3 billion net write-down, implying that they are 72% hedged on their exposure to Residential Mortgage positions. Their commercial positions saw a $1.2 billion gross write-down, and a $900 million net write-down, suggesting they are only 25% hedged to their commercial positions.

I believe that the commercial mortgage/real-estate market still has a ways to go on the downside, and is much earlier in its trajectory than the residential market (as I'm sure you'll agree judging by some of your posts on the subject). Lehman's residential and commercial mortgage exposures are roughly equivalent ($37.3 vs $38.9 billion as of 11/30/07).

I also believe that even on a gross basis, Lehman has not taken large enough write-down in comparison to other companies. I believe they have accomplished this by moving mortgage assets to Level 3. I've loved reading your blog and truly appreciate the unique and in-depth analysis performed on target companies thus far."

The monolines (after losing 90% of their share value) are now mutually agreeing with I banks to commute the liabilities of their CDS. Basically, those paper hedges aren't really hedges that are going to be there next quarter. Uh oh! What do we do now? 

Lehman is not the only bank to to this. All of the banks did it. How else would you hedge $50 billion of illiquid, untradeable assets??? Watch the truth leak out of the rest of the banks in the upcoming quarters.


Creation of colossal US$45 trillion CDS market may unfold into trouble larger than subprime crisis

The creation of the massive US$45 trillion CDS market in the last few years, which faces some unique problems, can unfold into a massive bubble collapse that would easily dwarf that of the subprime crisis. The CDS are supposed to cover the losses of banks and bondholders in the event of default by companies. However, the CDS market has evolved from being primarily a means to hedge credit risk to a speculative and trading platform for a large number of banks and hedge funds. If the corporate defaults surge in the coming quarters (as Reggie Middleton, LLC expects them to) or there is default in payments of coupon and principal amounts, this could lead to a crisis far worse than what we have seen so far in the current “asset securitization crisis” and quite possibly in the recent history of the financial system. The high yield default rate has increased significantly (125%) in the last few quarters from 0.4% in 1Q 07 to almost 0.9% in 1Q 08. In addition, the monolines which are under considerable stress and play the role of both counterparty as well as the reference entity in the CDS market could spell major trouble for the market participants.


Spectacular growth of credit risk transfer instruments 


1 In trillions of US dollar. 2 Of BIS reporting banks; cross-border and local foreign currency claims. 3 Annualised. 4 Sum of cash tranche sizes by pricing date; includes only cash and hybrid structures. Hybrid portfolios consisting mainly of structured finance products different from cash CDOs are excluded. 5 Covers about 80% of index trade volume, according to CreditFlux Data+.

Source: IMF, CreditFlux Data, ISDA ; National Data; BIS Calculations


The single name CDS has reported strong growth in the last few years growing from $7 trillion in June 2005 to $24 trillion in June 2007. Recently, the growth in single name CDS is lagging that in the multi name CDS as the growing popularity of the multi name products mainly the index CDS along with LCDS, LCDX and synthetic CDOs have gained in importance.


Source: Bank for International Settlement


The Below Investment Grade (BIG) (or junk) single name CDS contracts notional amount outstanding has increased to US$3.2 trillion in June 2007 from US$1.5 trillion in December 2005. At the same time the non-rated (again, junk) single name CDS contracts outstanding has increased to US$5.3 trillion from US$1.6 trillion.

The activity in the CDS market has also been driven by the increased issuance of synthetic collateralized debt obligations (CDOs) and other structured products that use CDS to obtain the credit exposure. However, the impact of such issuance on positions in the CDS market could be higher than reported by nominal amounts, as hedging structured credit products may involve selling a multiple of their face value, in particular in the case of more junior tranches whose prices are very sensitive to market conditions. Consequently, the effect of structured issuance on CDS volume is extremely difficult to measure correctly.


Source: Bank for International Settlement


The gross market value of CDS contracts have grown from US$188 billion in June 2005 to US$721 billion in June 2007, with multi name CDS growing significantly in the last few years.


Source: Bank for International Settlement


The global CDS market exposure has US$24.4 trillion of the assets in the tenor of maturity 1 to 5 years and US$15.4 trillion with maturity of over 5 years.


There has been a steady rise in the exposure toward below investment grade securities raising concerns on the increased chances of credit events happening in the CDS market. The BIG exposure of 40% in the credit derivative market, and 25% exposure toward BBB rated entities could eventually emerge into a potentially dangerous situation if the credit events trigger. Exposure to BIG securities has increased from a low of around 7.5% in 2002 to 40% in 2006, while exposure towards AAA has declined significantly. Reggie Middleton anticipates a significant surge in defaults in the lower and mid range  of the credit quality spectrum as credit tightens and the negative macro environment takes effect on earnings and cash flows for marginal companies and market participants.



The trend toward lower-quality and unrated reference entities continued last year. According to a Fitch Report, approximately 38% of all CDx referenced at the end of 2006 was either speculative grade or unrated, as compared to 34% in 2005 and a mere 18% in 2003. This is attributable to market maturation as well as investors’ continuing search for higher yielding risk exposures in the spread-constrained environment.


The Global banks are primarily the net buyers of insurance while the insurance companies and financial guarantors are the net sellers of protection.


Major sectors witnessing the rise in CDS spreads – Insurance, Banking & Finance, Real Estate and Building & Materials – sectors that have been talked about the most on!!!


Percent Change in CDS spread by industry - 2007


Source: Fitch ratings

Percent change by CDS spread by industry – January 2008


Source: Fitch ratings

 The global industrial sector has reached the nadir of its business cycle and is approaching a sharp downturn, accelarated by the shove given by gorging on excessive and mis-priced esy credit that cannot be rolled over! Even without the mortgage related malaise that we are going through, the CDS system "Domino Effect" most likely will be set off anyway!


Rise in corporate defaults may spark off a chain reaction

According to Standard & Poor (S&P) ratings services, corporate defaults in the first quarter of 2008 in the US is beginning to climb significantly, keeping pace with the total number of defaults in 2007 and are expected to gain momentum through the rest of 2008 and 2009. S&P in its report "U.S. Corporate Default Outlook: Defaults rev up as leverage unwinds” stated that out of the 17 global corporate defaults in 1Q 08, 16 were US based defaults impacting debt worth US$8.8 billion. At the end of March 2008, the trailing 12-month issuer-based global default rate for all rated entities rose to 0.48 %. By region, the default rates were 0.70% in the US, 0.09% in Europe, and 0.10% in the emerging markets.


The global default rate for speculative grade entities was 1.14%, below the long term average of 4.35%. The US led the charge, with its speculative-grade default rate increasing to 1.40% after reaching a 25-year low of 0.97% in December 2007. S&P expects the US speculative-grade default rate to shoot up to a mean forecast of 4.7% in the next 12 months, which very well may stress test the newly burgeoned CDS market with the mystery web of credit counterparties.


US high yield default rate has been very low for several years


Source: Bloomberg and Fitch ratings

As can be seen from the graph above, we are at a trough in defaults and loss rates, and a peak in recovery rates. Even assuming we don’t enter into a historically significant default scenario, a simple return to mean values will seriously test the CDS markets as they now stand.


The US high yield default rate has been trending up


Source: Bloomberg and Fitch ratings