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 boombustblog.com 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

Worsening credit market to impact Morgan Stanley’s financial position

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

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

Despite Fed’s initiatives, liquidity concerns remain persist

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 BoomBustBlog.com, 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.
http://blogs.wsj.com/marketbeat/2007/09/21/great-moments-in-accounting/

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 BoomBustBlog.com!!!

 

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