Tuesday, 26 October 2010 12:21

Wall Street Responds to My Roadmap of the Derivative Meltdown

I have received a lot of feedback concerning my article posted yesterday, A Step by Step Guide to Exactly How Much Derivatives Risk Each of the 5 Big Banks Actually

Pick up your own "Fiery Swords of Truth" and aggressively seek out the facts. Don't be afraid to ask questions under the pretense you don't understand. Chances are, if it is so complex that you can't understand it, it is either wrong or many other people, including the creators and proponents, don't understand it either!!!

Have, and How It Could All Go Boom! (a must read precursor to this piece) in which I picked up the fiery sword of Truth and attacked all misinformation within reach. A decent amount of derivatives traders, salesman and financial engineers chimed in. Of course, being the simpleton that I am, I am at a loss how anybody can argue that the hedging and netting system actually works with the utter failure of the monolines, Lehman (wherein contracts were unwound and rewritten, but why would they have to be if everybody was netted???) and Bear Stearns (where the government had to step in to be the counterparty of last result), all of which allegedly netted out much of their risk - RIIGHHHT??? Nonetheless, I will go through some of the responses I received via email, all of which were cogent, intelligent and polite - but most of which took a swing at my thesis. Okay, I'm swinging back - and I'm swinging back with the "Fiery Sword of Truth" as well!

Here's the first one:

Hi reggie, love the independance of the blog. Couldnt help but wonder though, as to if the big 5 were really cross exposed to that degree. Surely hedge funds, private banks, real world commodity producers etc are other swap counter parties that you fail to include in your calculations. 1.7 trillion of unlevered hedge fund assets arent included anywhere for a start. How about other smaller banks too, that dont show up in the comparison, maybe there is more diversification than you think.

My initial response to him was going to be:

"Maybe, but the OCC numbers don't show it. Remember, I was calculating interbank derivative exposure, not total derivative exposure. In addition, entities such as hedge funds and family offices are implosions waiting to happen in terms of risk and risk management. How many <$100 to $999 million funds and offices do you think could truly handle a systemic call on collateral? What are the size of their risk management departments? Yeah, I know, "What risk management departments? They use the software supplied by their prime broker to handle that stuff!" I know for a fact that TRS and CDS were pushed on tiny funds so banks could say that they were hedged or exposure was netted out."

Then I decided to to in depth in answering him. We have about $202 trillion in notional between just FIVE banks. Compare that to $1.7 trillion in unlevered hedge fund assets, of which about about 3% would be (prudently) dedicated to CDS. So that is  roughly $51 billion in net equity going into CDS. Let's lever it 5 times, so that's $250 billion. The total net fair value to notional proportion for the big banks is about .25%, give or take...

So, we're talking just over $60 trillion in hedge fund CDS, that is assuming the guest above is correct in his assumptions. If one were to double the leverage amount, we will come out to about $120 trillion through hedge funds. Now, my question is.....  "Is this suppose to be a good thing?" Let's assume that I was incorrect, even though I don't think I was since I sourced the OCC numbers and banks face most of these CDS, but let's just assume. Who do you think would have even more lax of a risk management structure than big investment and commercial banks? You got it?

When I was trying to start up my fund in 2007, I was being pitched TRS (total return swaps). I probably wouldn't have had more than $50 million to $75 million of equity, yet I was being pitched these things. It really didn't matter of I was able to make good on them or not. So, why would I be pitched such products? So banks can say they were "netted" out (lying) and fully hedged (lying more), hence able to release capital to do more dirty dastardly deals based in derelict trash that would have normally been locked up and held as reserves. I will cover the topic of hedging a little later on this missive, but for now let's delve into how risky it is to count a hedge fund as a AAA, sterling counter party - and why banks will do it anyway.

Excerpted and modified from a post that I in June of 2008 titled CDS stands for Credit Default Suckers…

UBS asked Paramax Capital International to sell it protection on $1.3bn of the most highly rated slices of a CDO [you know, that AAA, super senior, overcollaterlized stuff] made up of subprime residential mortgages that the UBS investment bank underwrote. In general, [actually, supposedly, since most of us laden with common sense knows this is bullshit] by hedging the risk fully through the credit derivatives market, banks can remove such exposures from their balance sheets and do not have to set aside capital

I want all to ponder the afore-quoted phrase, as underlined. We will dive into the folly of such forthwith. For those not familiar with the games financial engineers play turning shit to gold with a little spit shine, see  the tribulations of monoline insurers such as Ambac and MBIA, (by blog's subscribers first 20x+ baggers, enormous returns from puts bought for pennies and sold for thirty and forty dollars) see A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton circa November 2007). Here's the story in a graphical nutshell...

and then...

Now, back to the story at hand...

Paramax claims that, from the beginning, the UBS hedge was cosmetic. In May 2007, when the original agreement was signed, the terms were a fraction of the market rate.

Why agree to such thin terms? You put yourself at risk, no?

Also, Paramax had only $200m under management and its agreements with its own investors limited it to commit no more than $40m to any single deal. Thus, it could never compensate UBS fully for any meaningful loss in value of the $1.3bn UBS was trying to insure, it claims.

So, Paramax must be in the monoline insurance biz Sealed. I know, that was a low blow…

Paramax also claims that UBS told it that the bank would employ “subjective valuation methodologies” that meant it would not record any loss in value that could trigger calls for additional margin from Paramax…

You set yourself up for this one fellas!

Paramax also claims that UBS promised that if the lender needed a “real” hedge, it would tear up the agreement…

I can’t wait for this to be defined in court and made precedent. Let’s repeat that again, ” A “real” hedge”! I’ll paraphrase a huge part of the article for you. The market turned to shit, and the banks started to pretend that they had “real hedges” instead of the capital "placeholders" they arranged with hedge funds, family offices, and UNHWs.

Now UBS is taking Paramax to court, seeking to compel it to pay up as the securities drop in value, alleging breach of contract. Paramax in turn is charging UBS with negligent misrepresentation. UBS said the bank was confident in the merits of its case. A lawyer for Paramax said its allegations were supported by both written and oral statements. The combination of subjective valuation and hedges that may not be real because counterparties cannot or will not pay goes way beyond UBS and Paramax.

Oh boy, does it. Monolines, investment banks, commericial and mortgage banks, homebuilders mortage finance arms, leasing and consumer finance companies. I can really go on. Remember these posts, ya’ll:

Remember, these CDS were used as hedges, and often support other positions. For instance, I buy a CDO, hedge it with Paramax (instead of a “real hedge”), then take the freed up (should have been reserved, here's to  you JPM!!!) capital from the hedge and do another nonsense leveraged deal with it using less than optimal capital because it was “hedged” with a Credit Default Sucker” (sorry about that, I meant by a swap/CDS). I then keep going on until I have maxed out my leverage and available capital, which is only indicated at 20 to 35x on my 10Q, but the actual leverage is much more when you consider my use of Credit Default Suckers! Again, reference Banks, Brokers, & Bullsh1+ part 2 for how quickly this can build up.

For example, in one case the seller of credit protection discovered that the final agreement on insuring a portfolio of collateralised debt obligations had never been signed, either by it or a French bank which in this case was buying protection. Now, with the meltdown in that market, the seller has returned all the premium payments to the buyer and torn up the agreement, saying that because it was never signed, it has no legal obligation to pay up…

No need to fret, Paulson and a bevvy – I mean a plethora – of financial CEOs state that the worst is behind us…


Then there was this comment posted on one of the popular financial blogs:

As an aside, you have no way of understanding (from the outside) how exposure to counter-parties net and cancel.

I warned about the under appreciated counter party risks nearly two and a half years ago. One would think that regulators would subscribe to the BoomBust! Let's reminisce, going back to May 28th, 2008

Lack of regulatory authorities in the credit insurance market

The valuation of CDS contracts by banks and other institutions are typically done based on statistical models as they are generally bought and sold in the over the counter (OTC) derivative market. The nonexistence of any exchange or centralized clearing agent where these quasi-insurance contracts trade results in their prices not being reported to the general public. Furthermore, as the CDS contracts are sold and resold again and again among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim raising doubts about the counterparty failure and the impact on its books.

The lack of regulations and proper settlement mechanisms in the CDS market saw the Aon Corporation (AON) book a huge loss on its protection sold to Bear Stearns. Aon, having sold credit protection to Bear Stearns, had hedged itself by purchasing protection from Societe Generale but had to ultimately bear the loss as it was unable recover losses from Societe Generale.

Bear Stearns provided a loan of US$10 million to a Philippine entity and demanded the borrower obtain a surety bond from a Philippine government agency, the Government Service Insurance System (GSIS). Bear Stearns, to further hedge default risk on the US$10 million loan purchased protection contract from AON for US$0.425 million. AON, to hedge this risk purchased protection from Societle Generale for US$0.3 million believing it made a cool profit of US$0.1 million. [Remember that daisy chain effect that I warned you about.] However, as the Philippines entity defaulted and the GSIS refused to pay on the surety bond, Bear Stearns sued AON based on the first CDS contract, which AON lost and had to eventually pay US$10 million to Bear Stearns. AON then went on to sue Societe Generale, and argued that the court's finding in the first action, that a "Credit Event" requiring payment had occurred under first CDS, mandated a similar result with respect to the second CDS. The district court initially ruled in favor of AON, but as Societe Generale appealed, the court ruled in favor of Societe Generale resulting in AON bearing a loss of US$10 million. My analysts have made the case available: Aon/SocGen case 86.42 Kb and for general reading, see The Basel Committee on Banking joint_forum on Credit Risk Transfer_2008_update.

Now, if one were to multiply this by tens of thousands of transactions and by multiples of billions of dollars, you can begin to see the gravity of the counterparty and credit risk that abounds in the unregulated CDS markets! The court reversed its decision and ruled in favor of Societe Generale, stating that "the terms of each credit swap independently define the risk being transferred." The court parsed the language of second CDS and noted that "the risk transferred to AON and the risk transferred by it was not necessarily identical." AON had sold Bear Stearns protection that expressly included a failure to pay by GSIS as a Credit Event. However, what it bought from Societe Generale was slightly different. The second CDS contained protection against a condition resulting from any act or failure to act by the Government of the Republic of the Philippines or any agency thereof that has the effect of causing a failure to honor any obligation issued by the government of the Republic of the Philippines. The risks for which protection was sold under first CDS and second CDS did not match up. From a legal and practical perspective, this caveat is a potential time bomb for all OTC CDS contracts and transactions that are custom scripted and not cleared through a universal exchange. Although the US banking system is working towards a centralized clearing house for CDS, the current system is a time bomb waiting to be bailed out! [This should read bailed out again, for it was written before AIG was bailed out for $183 billion!!!]

The judgment was that the first CDS contract and the second CDS contract are two separate contracts, the language is slightly different too, so legally, the resolution of the first CDS doesn't automatically grant the similar conclusion to the second CDS. Thus, the judgment to pay Bear Stearns can't be used and referenced for the second lawsuit, as a result, the risk can't be assumed to automatically be transferred. If one were to extrapolate the results of this case to the broader environment, combined with the murky credit risks and liquidity issues in times of duress, it is easy to come to the conclusion that CDS held by banks, hedge funds and large institutions for the purpose of risk management are quite the IMPERFECT hedge.

The court concluded and I quote “We therefore conclude that neither the default, which constituted a Failure to Pay under the Bear Stearns/AON CDS contract, nor the Republic's failure to honor its alleged statutory obligation, constituted a Failure to Pay under the AON/Societe Generale CDS contract. For the same reasons, neither event constituted a "Repudiation." They similarly do not satisfy the other definitions of Credit Event enumerated in the AON/Societe Generale CDS contract.

Counterparty bankruptcies that can result in a domino effect across the financial system – getting a clearer idea of why Bear Stearns was bailed out!!!

The valuation of CDS insurance contracts on the books of various banks who bought protection will be largely impacted in case of counterparty bankruptcies. Under normal circumstances, a bank believes that it is hedged against the corporate bond exposure as it has bought protection in the CDS market and does not write off the losses on its bond holdings. However, in the event of the counterparty who sold insurance is unable to pay its clams, then the banks needs to book the loses in its account (in addition to the sunk cost of the CDS premium) which could lead to more writedowns and severely dent profitability and in many cases, solvency.



This was the most recent email, and he brings up some interesting points...

Reggie Middleton,

Enjoyed your last effort.

I have a few suggestion for you:

1) Could it be that the thing to look for is not that one or more of the big banks' derivatives books is not earning too little but too much?

You know, in rough terms, if you're looking at a CDS book where yield spread - asset spread is 30BP and you're getting 40 BP, you think you're in clover. But WHY are you getting 40 BP? This leads to the question...

2) Who's the patsy? [Reggie here: THIS is what the game is all about. Create enough opacity in proprietary pricing and limit price discovery enough to spread margins past that of what a totally transparent market would ever tolerate. Yet, in order to do that, you need a CDS (credit default sucker), a chump, a patsy!]

Whether it's AIG, Clayton, MERS, the ratings agencies, the outside packagers, or the sercuritization "managers", modern "control fraud" at major banks seems to depend on patsies. To the extent that bankers at major firms do bad stuff, they tend quickly to move that bad stuff outside the company.

So if JPM and the like are doing bad stuff, who are their new patsies? One set of new patsies is the foreclosure mills. Note: their patsies are also going to be co-conspirators, whether by accident or design. Who else do they need? When JPM got so big in derivatives, how did they do it so suddenly? How are they selling and processing all those trades? Whom do they call on when they've got a big fish on the line and they need to move risk?

On a separate track (or maybe not), I don't want to be like Columbo here, but "just one more thing": Santander.

Doesn't it seem remarkable - I mean really, really noteworthy - that a Spanish bank should be able to expand that quickly AFTER the crisis? I mean all these banks telling us that they are gonna use the crisis to snap up the little fish and none of them can make it work (whatever they may say), but Santander can? Really? And Santander just happens to be in a country whose CB uses a novel accounting system. You don't think Santander had anything to do with the adoption of that system, do you?

And suddenly Santander is expanding rapidly into countries with histories of massive control frauds. Whole new vistas over there in Brazil, Mexico and Chile - new derivatives markets, for example. Can't seem to digest their new UK holdings, but seem determined to expand very fast just the same. Interesting, isn't it?

I mean, you don't think a bank like Santander would be swapping near term cash flow for (what they hope is) out-year default risk, do ya?

Just bothers me, you know? But maybe I'm cynical.

Good Luck,



Here's a little tidbit in the news that can demonstrate just how much capital can eaten up by ONE company on the wrong side of CDS ($183+ billion, ~ with $45 billion in losses and steady counting). From the NY  Times, via CNBC:

The United States Treasury concealed $40 billion in likely taxpayer losses on the bailout of the American International Group earlier this month, when it abandoned its usual method for valuing investments, according to a report by the special inspector general for the Troubled Asset Relief Program.

What else is new?

... In early October, the Treasury issued a report predicting that the taxpayers would ultimately lose just $5 billion on their investment in A.I.G., a remarkable outcome, since the insurance company was extended $182 billion in taxpayer money in the early months of its rescue. The prediction of a modest loss, widely reported as A.I.G., the Federal Reserve and the Treasury rushed to complete an exit plan, contrasted with an earlier prediction by the Treasury that the taxpayers would lose $45 billion. “The American people have a right for full and complete disclosure about their investment in A.I.G.,” Mr. Barofsky said, “and the U.S. government has an obligation, when they’re describing potential losses, to give complete information.”

An official of the Treasury disputed Mr. Barofsky’s conclusions, saying the department appropriately used different methods for different purposes. He said the smaller loss was a projection of future events, and the larger one was the result of an audit, which includes only realized gains and losses.

Mr. Barofsky, silly man!!! Don't you understand the simple elementary math? The smaller loss was an imagination figment, based on what may happen in the future that could allow them to print minimized losses!!! The larger number was, well,,,, actually losses!!! You silly guy, you. In all seriousness, if you can even get to that point, what is truly interesting is that there is no mention of unrealized losses or gains. Since most of this stuff was based on real estate underlying, the government paid top dollar par value for this stinky prize and the real estate market is still going down and will not return to the levels of 2007 on a nominal basis for at least a decade and on a real basis for probably a life time, those unrealized losses will most likely have to be realized at some point in time.

... “If a private company filed information with the government that was just as misleading and disingenuous as what Treasury has done here, you’d better believe there would be calls for an investigation from the S.E.C. and others,” said Representative Darrell Issa, the senior Republican on the House Committee on Oversight and Government Reform. He called the Treasury’s October report on A.I.G. “blatant manipulation.”

Well, hold your horses there. I can name a bank and REIT or two that have issued numbers just as bogus, and the regulatory bodies' apparent blessing...

Senator Charles E. Grassley of Iowa, the senior Republican on the Finance Committee, said he thought “administration officials are trying so hard to put a positive spin on program losses that they played fast and loose with the numbers.” He said it reminded him of “misleading” claims that General Motors had paid back its rescue loans with interest ahead of schedule.

Mr. Barofsky said he had written to the Treasury secretary, Timothy F. Geithner, in mid-October, after widespread reports in the news media about the possibility that the Treasury could wind down its position in A.I.G. with just a $5 billion loss. He recommended that the Treasury correct the October report, perhaps by adding a footnote saying the methodology for calculating its losses had changed.

The Treasury declined. It sent back a letter saying its methodology for calculating losses had not really changed, although its assumptions had.

Oh... Okay!

Required reading:

A Step by Step Guide to Exactly How Much Derivatives Risk Each of the 5 Big Banks Actually Have, and How It Could All Go Boom!

Did Reggie Middleton, a Blogger at BoomBustBlog, Best Wall Streets Best of the Best?

Four Facts That BANG JP Morgan That You Just Won’t Hear From The Sell Side!!!

JP Morgan’s 3rd Quarter Earnigns Analysis and a Chronological Reminder of Just How Wrong Brand Name Banks, Analysts, CEOs & Pundits Can Be When They Say XYZ Bank Can Never Go Out of Business!!!

We’ve Been Bamboozled by the Banking Industry, but the Chickens Are Coming Home to Roost

The Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage Putbacks Will Be the Harbinger of the Collapse of Big Banks that Will Dwarf 2008!

A Quick Peek Into the REAL WORLD Logic That Went Into Building the BoomBustBlog Apple Model: It’s Called Compression!!!

JP Morgan’s Analysts Agree with BoomBustBlog Research on the State of JPM (a Year Too Late) but Contradict CEO Jamie Dimon’s Conference Call Statements

BoomBustBlog Research Hits Another One Out the Park! Google up nearly 10% after hours, true blowout earnings unlike JPM

Reggie Middleton and Karl Deninger Discuss Foreclosure Fraud and Banks on the Market Ticker’s Blogtalk Radio

Last modified on Tuesday, 26 October 2010 13:26

3 comments

  • Comment Link bad credit surety bonds Wednesday, 03 November 2010 01:39 posted by bad credit surety bonds

    hey, I added ur site to my RSS reader. thnx the posts are awesome!

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  • Comment Link Andrew Macpherson Thursday, 28 October 2010 12:12 posted by Andrew Macpherson

    Thanks as always - a great, but not a happy, morning read.

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  • Comment Link eddbrowne Thursday, 28 October 2010 01:02 posted by eddbrowne

    Wall Street packaged GWB as AAA, and the rest is misery.

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