The  day before yesterday I posted Who Will Be The Next JPM? Simply Review The BoomBustBlog Archives For The Answer. It was actually a very, very instructional post for although I run a subscription research service, there are troves of extremely insightful information buried in the archives - much of it available for free. It is actually ironic that one could have used the actual paid product to have predicted the events of this year with unerring accuracy two years ago, and using much of the same names from the 2008/9 archives profited heavily from the financial names that gave up 20% of the last few weeks. The more things change, the more they remain the same, eh? Which brings us to one of the first big warnings published on BoomBustBlog way back on Thursday, 08 May 2008: Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)

Creation of colossal US$45 trillion CDS market may unfold into trouble larger than that of the subprime (really to be read as imprudent underwriting) 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

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Fastforward five full years, and has anybody learned there lesson? Well, prance through the recent BoomBustBlog headlines to find the answer:

• Is The Entire Global Banking Industry Carrying Naked, Unhedged "Risk Free" Sovereign Debt Yielding 100-200%? Quick Answer: Probably!

If you don't trust the thoroughly researched, high end alternative info sources such as BoomBustBlog, realize that today Bloomberg reports U.S. Banks Sold More Insurance on Europe Debt, as annotated and excerpted: 

U.S. banks increased sales of protection against credit losses to holders of Greek, Portuguese, Irish, Spanish and Italian debt in the last quarter of 2011 as the European debt crisis escalated.

Well you can't say they didn't see this coming, for I warned throughout 2010 via the Pan-European sovereign debt crisis series.

Guarantees provided by U.S. lenders on government, bank and corporate debt in those countries rose 10 percent from the previous quarter to $567 billion, according to the most recent data from the Bank for International Settlements. Those guarantees refer to credit-default swaps written on bonds.

JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc., two of the top CDS underwriters in the U.S., say they have bought more protection than they sold, indicating they may benefit from defaults in the region. That outcome is called into question by JPMorgan’s $2 billion loss on similar derivatives, which shows that risks don’t vanish when offsetting bets are taken, said Craig Pirrong, a finance professor at the University of Houston. “All these hedges trade one risk for another,” said Pirrong, whose research focuses on derivatives markets.

EXACTLY!!!! Risk doesn't disappear when you buy a hedge, it's simply shifted and transformed. In the case of the aforementioned 2008 article and my ramblings about the banks and insurers, naked credit (and market, depending on how the hedge was constructed) risk was simply traded for counterparty risk. With 96% of notional derivative exposure concentrated in just 6 banks - all with excessive leverage, opaque VouDou accounting (Sak Passe'), and tummy full of hidden NPAs amongst one of the worst macro environments of several lifetimes , one must question, "Is the counterparty risk one just assumed greater than the credit/market risk sold, combined?"

“The banks say they’re flat on European risk, but that’s based on aggregated positions. We don’t know how those will hold off if the European crisis blows up.”

JPMorgan Chairman and Chief Executive Officer Jamie Dimon said last week that the bank was trying to reposition a portfolio of corporate credit derivatives and used a flawed trading strategy. The lender, the largest in the U.S. by assets, is believed to have sold protection on an index of corporate debt and bought protection on the same index to hedge its initial bet, according to market participants who asked not to be identified because their trading strategies aren’t public.

The two bets moved in opposite directions this year, causing losses and proving that even hedges that look perfect can break down, Pirrong said.

Once again for the unitiated, shall we?

Reggie Middleton on CNBC's Squawk on the Street - 10/19/2010

Mr. Middleton discusses JP Morgan, bank risk and technology and is the only pundit in the financial media that we know of that called Apple's margin compression issues and did so successfully just hours before they reported! Click here or click below to see the video.

Here's a subscription dump of our archives for JPM to placate the insatiable thirst of the BoomBustBlog paid subscriber: JPM Q1 2011 Review & Analysis   JPM 3Q 2010 Forensic Update  JPM Public Excerpt of Forensic Analysis Subscription JPM Restricted Stock scheme JPM 2Q10 review  JPM 1Q 2010 Valuation Review   JPM 4Q09 review  JPM Report (092209) Final - Professional09/24/2009 JPM Forensic Report (092209) Final- Retail JPM Option Analysis

For those who have not read my seminal piece on Dimon's house of Morgan, JPM Public Excerpt of Forensic Analysis Subscription published nearly three years ago, allow me to take the liberty to excerpt it for you...

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JPMorgan, Goldman Sachs

JPMorgan said in a regulatory filing that it purchased $144 billion of CDS related to the five European countries as of the end of the first quarter, while it sold $142 billion. Goldman Sachs (GS) bought $175 billion of protection and sold $164 billion, the firm said in its filing.... Bank of America Corp., Morgan Stanley (MS) and Citigroup Inc. (C) report only net CDS exposures. The five banks together account for 96 percent of the credit-derivatives market in the U.S., according to the Office of the Comptroller of the Currency. JPMorgan has written a quarter of the total, the OCC data show.

And here's the BoomBustBlog version of events:

I'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & IntroductionI'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & Introduction	I'm Hunting Big Game Today: The Squid On A Spear Tip Summary: This is the first in a series of articles to be released this weekend concerning Goldman Sachs, the Squid! In this introduction (for those who do not regularly follow me) I demonstrate how the market, the sell side, and most investors are missing one of the biggest bastions of risk in the US investment banking industry. I will also...
Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?	Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored? Welcome to part two of my series on Hunting the Squid, the overvaluation and under-appreciation of the risks that is Goldman Sachs. Since this highly analytical, but poignant diatribe covers a lot of material, it's imperative that those who have not done so review part 1 of this series, I'm Hunting Big Game Today:The Squid On The Spear Tip, Part...
Reggie Middleton Serves Up Fried Calamari From Raw Squid: Goldman Sachs and Market Perception of Real Risks!Reggie Middleton Serves Up Fried Calamari From Raw Squid: Goldman Sachs and Market Perception of Real Risks!	Hunting the Squid Part 3: Reggie Middleton Serves Up Fried Calamari From Raw Squid For those who don't subscribe to BoomBustblog, or haven't read I'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & Introduction and Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?, not only have you missed out on some unique artwork, you've potentially missed out on 300%...
Hunting the Squid, part 4: So, What Else Can Go Wrong With The Squid? Plenty!!!Hunting the Squid, part 4: So, What Else Can Go Wrong With The Squid? Plenty!!!	Hunting the Squid, part 4: So, What Else Can Go Wrong With Goldman Sachs? Plenty! Yes, this more of the hardest hitting investment banking research available focusing on Goldman Sachs (the Squid), but before you go on, be sure you have read parts 1.2. and 3:  I'm Hunting Big Game Today:The Squid On A Spear Tip, Part 1 & Introduction Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To...

Matched Protection

Not all protection sold by banks is matched exactly by protection bought. CDS purchased and sold on Spanish sovereign debt can have different expiration dates. Banks also can net a swap on a Spanish bank with one on another lender. Even if those two firms are in a similar condition at the time of the trades, one could deteriorate faster, increasing the cost of CDS.

Some of the swaps sold by U.S. banks were bought by European lenders trying to reduce exposure to the five so-called peripheral countries. Since it’s considered insurance, a German bank can subtract the value of the contracts it purchased on Spanish debt from the total value of its holdings, with the understanding that if Spain doesn’t make good on its payment, the CDS underwriter will pay instead.

British, German and French banks’ loans to the five countries were reduced by 5 percent in the fourth quarter to $1.33 trillion, according to the BIS data. That was a $73 million decrease compared with the $53 million increase in U.S. banks’ CDS exposure to the periphery.

... Bank Losses

More than half of the CDS related to Spain, Italy and Portugal were to protect defaults by companies in those countries, not the government, according to data compiled by the Depository Trust and Clearing Corp., which runs a central registry for over-the-counter derivatives. About a quarter of the total in each country was protection on bank debt.

As banks in the five countries face mounting losses and funding strains, it’s impossible to model accurately how the risk on different institutions will change, Rowady said. Government and central bank interventions in markets can also upset correlations in those models, he said.

Now, I wouldn't go so far to say that it's impossible. After all, we did it and BoomBustBlog subscribers benefitted from it. Reference The BoomBustBlog Contagion Model: How We Predicted 9 Months Ago That The UK and Sweden Would Rush To Bail Out Ireland, and Why and Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!.

The BoomBustBlog Sovereign Contagion Model

Nearly every MSM analysts roundup attempts to speculate on who may be next in the contagion. We believe we can provide the road map, and to date we have been quite accurate. Most analysis looks at gross claims between countries, which of course can be very illuminating, but also tends to leave out many salient points and important risks/exposures.

foreign claims of PIIGSforeign claims of PIIGSforeign claims of PIIGS

In order to derive more meaningful conclusions about the risk emanating from the cross border exposures, it is essential to closely scrutinize the geographical break down of the total exposure as well as the level of risk surrounding each component. We have therefore developed a Sovereign Contagion model which aims to quantify the amount of risk weighted foreign claims and contingent exposure for major developed countries including major European countries, the US, Japan and Asia major.

I.          Summary of the methodology

• We have followed a bottom-up approach wherein we have first identified the countries/regions with high financial risk either owing to rising sovereign risk (ballooning government debt and fiscal deficit) or structural issues including remnants from the asset bubble collapse, declining GDP, rising unemployment, current account deficits, etc. For the purpose of our analysis, we have selected PIIGS, CEE, Middle East (UAE and Kuwait), China and closely related countries (Korea and Malaysia), the US and UK as the trigger points of the financial risk dissemination across the analysed developed countries.
• In order to quantify the financial risk emanating in the selected regions (trigger points), we looked into the probability of the risk event happening due to three factors - a) government default b) private sector default c) social unrest. The probabilities for each factor were arrived on the basis of a number of variables determining the relative weakness of the country. The aggregate risk event probability for each country (trigger point) is the average of the risk event probability due to the three factors.
• Foreign claims of the developed countries against the trigger point countries were taken as the relevant exposure. The exposures of each developed country were expressed as % of its respective GDP in order to build a relative scale for inter-country comparison.
• The risk event probability of the trigger point countries was multiplied by the respective exposure of the developed countries to arrive at the total risk weighted exposure of each developed country.
•  Sovereign Contagion Model - Retail - contains introduction, methodology summary, and findings
•  Sovereign Contagion Model - Pro & Institutional - contains all of the above as well as a very detailed methodology map that explains what went into the model across dozens of countries.

Latest Pan-European Sovereign Risk Non-bank Subscription Research

• Ireland public finances projections_040710
• Spain public finances projections_033010
• UK Public Finances March 2010
• Italy public finances projection
• Greece Public Finances Projections

Back to Bloomberg...

Last week, Spain’s government took control of Bankia SA (BKIA), the country’s third-largest lender, and asked banks to increase provisions for souring real estate loans. Losses of Spanish banks could top 380 billion euros, according to the Centre for European Policy Studies. Moody’s Investors Service downgraded the credit ratings of 16 Spanish banks yesterday and 26 Italian lenders earlier this week.

Oh yeah, we caught Spain too - as far back as 2008/9/10. Yes, the Spain pain was apparent 4 years ago. Follow the BoomBustBlog archives, starting with a post from this month The Spain Pain Will Not Wane: Continuing the Contagion Saga and going back to '09 - The Spanish Inquisition is About to Begin... and even farther back to '08 - Reggie Middleton on the New Global Macro - the Forensic Analysis of a Spanish Bank. Back to the Bloomberg article...

Counterparty Failure

Counterparty failure is another risk for banks selling insurance on the debt of the five counties. When a swap is triggered by default, a bank could find that a client who sold the protection can’t pay. The firm still has to make good on its promise to pay whoever bought protection.

Lenders try to mitigate this risk by asking for collateral from their counterparties as the value of CDS or other derivative changes. Dexia SA (DEXB) failed in October when the bank faced 47 billion euros of such margin calls on interest-rate swaps it sold. If Dexia hadn’t been bailed out by Belgium and France, it wouldn’t have been able to put up the collateral, causing losses for its unidentified counterparties.

U.S. banks didn’t suffer losses when swaps on Greek sovereign debt were paid out in March because prices of CDS had surged and collateral was collected in advance, according to Francis Longstaff, a finance professor at the University of California Los Angeles. While collateral protects middlemen from counterparty risk, there could be unexpected losses if the price of CDS doesn’t rise to reflect an imminent default, he said.

“Sudden defaults would shock the market because then you wouldn’t have the collateral to cover the full payment,” Longstaff said.

Banks also may discover that collateral they hold might not be worth as much, said University of Houston’s Pirrong. That happened in 2008 when banks saw the value of mortgage-related securities held as collateral plummet.

“Collateral is a great way to protect yourself,” Pirrong said. “But when the financial system is in a crisis, you might end up holding an empty bag.”

All of the afore-linked articles and info should lead one to do as I did, and query Is The Entire Global Banking Industry Carrying Naked, Unhedged "Risk Free" Sovereign Debt Yielding 100-200%? Quick Answer: Probably! Of course, I could always be more direct and simply state, Squids, Morgans & Counterparty Risk: Blowing Up The World One Tentacle At A Time. Honestly, though, how is it that so few banks (five or six) can attain and allegedly hedge hundreds of trillions of dollars of exposure, yet assert they only have billions of dollars of risk? Asked in a more laymen, ex. common sense fashion, So, When Does 3+5=4? When You Aggregate A Bunch Of Risky Banks & Then Pretend That You Didn't?

Of course, you know I'm going to say "I told you so!" Reference So, When Does 3+5=4? When You Aggregate A Bunch Of Risky Banks & Then Pretend That You Didn't? and then Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored? You see, in said piece, ZeroHedge dutifully reported that Five Banks Account For 96% Of The $250 Trillion In Outstanding US Derivative Exposure- a very interesting refresh of what I called out two years ago through "The Next Step in the Bank Implosion Cycle???":

The amount of bubbliciousness, overvaluation and risk in the market is outrageous, particularly considering the fact that we haven't even come close to deflating the bubble from earlier this year and last year! Even more alarming is some of the largest banks in the world, and some of the most respected (and disrespected) banks are heavily leveraged into this trade one way or the other. The alleged swap hedges that these guys allegedly have will be put to the test, and put to the test relatively soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk... ), you cannot truly hedge multi-billion risks in a closed circle of only 4 counterparties, all of whom are in the same businesses taking the same risks.

Click to expand!

bank_ficc_derivative_trading.png 

Again, from ZeroHedge: 

... and just for some clarity on how this occurred. We know the positions that Iksil held were in IG9 (more likely to be tranches) but this $2bn loss comes from a tiny 12bps decompression in the index - which means the DV01 must be huge...(as we already knew given the massive rise in net notional that we warned about)...

This is the Investment Grade credit index series 9 - which is the most active tranche-related index and was the index that Iksil had driven massively rich to its fair-value...

Of course, there's more to this story. After all, there is NEVER just one roach. I will cover that in my next post on the topic, which will entail COUNTERPARTY RISK. That's right, do you really think this will effect just JP Morgan?  In the meantime and in between time, here's a subscription dump of our archives for JPM to placate the insatiable thirst of the BoomBustBlog paid subscriber:

JPM Q1 2011 Review & Analysis

JPM 3Q 2010 Forensic Update 

JPM Public Excerpt of Forensic Analysis Subscription

JPM Restricted Stock scheme

JPM 2Q10 review

 JPM 1Q 2010 Valuation Review 

 JPM 4Q09 review

 JPM Report (092209) Final - Professional09/24/2009

JPM Forensic Report (092209) Final- Retail

JPM Option Analysis

 Well, there you have it! And executive director at Goldman Sachs has explicitly corroborated what I and many in the blogosphere have been crowing for some time now, and that is... 

The whole video can be seen here on the Max Keiser show, starting from about 19:00 minutes in where I discuss risk vs reward in GS and how they outperform eventhough risk outweighs reward. Those who like numbers and charts can see where I actually demonstrated in For Those Who Chose Not To Heed My Warning About Buying Products From Name Brand Wall Street Banks:

As in “When the Patina Fades… The Rise and Fall of Goldman Sachs???“, we can reminisce over the fact that Goldman BARELY earns its cost of capital on an economic basis, and that’s before considering the potential horrors which may (and probably do) lay on the balance sheet (for more on BS horror, referenceReggie Middleton vs Goldman Sachs, Round 2) .

GS return on equity has declined substantially due to deleverage and is only marginally higher than its current cost of capital. With ROE down to c12% from c20% during pre-crisis levels, there is no way a stock with high beta as GS could justify adequate returns to cover the inherent risk. For GS to trade back at 200 it has to increase its leverage back to pre-crisis levels to assume ROE of 20%. And for that GS has to either increase its leverage back to 25x. With curbs on banks leverage this seems highly unlikely. Without any increase in leverage and ROE, the stock would only marginally cover returns to shareholders given that ROE is c12%. Even based on consensus estimates the stock should trade at about where it is trading right now, leaving no upside potential. Using BoomBustBlog estimates, the valuation drops considerably since we take into consideration a decrease in trading revenue or an increase in the cost of funding in combination with a limitation of leverage due to the impending global regulation coming down the pike.

gs_roe.jpg

And now we have supporting evidence from the inside... From the NYT:

"TODAY is my last day at Goldman Sachs. After almost 12 years at the firm — first as a summer intern while at Stanford, then in New York for 10 years, and now in London — I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. I can honestly say that the environment now is as toxic and destructive as I have ever seen it."

"To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money."

"I knew it was time to leave when I realized I could no longer look students in the eye and tell them what a great place this was to work."

" I have always taken a lot of pride in advising my clients to do what I believe is right for them, even if it means less money for the firm. This view is becoming increasingly unpopular at Goldman Sachs. Another sign that it was time to leave."

 "How did we get here? The firm changed the way it thought about leadership. Leadership used to be about ideas, setting an example and doing the right thing. Today, if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence. What are three quick ways to become a leader? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym."

"I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client’s success or progress was not part of the thought process at all."

"It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

These days, the most common question I get from junior analysts about derivatives is, “How much money did we make off the client?” It bothers me every time I hear it, because it is a clear reflection of what they are observing from their leaders about the way they should behave. Now project 10 years into the future: You don’t have to be a rocket scientist to figure out that the junior analyst sitting quietly in the corner of the room hearing about “muppets,” “ripping eyeballs out” and “getting paid” doesn’t exactly turn into a model citizen."

More on the topic..

The Goldman Grift Shows How Greece Got Got

I've Told You Before, And I'll Tell You Again - Goldman Sachs Investment Advice Sucks!!!

Is It Now Common Knowledge ThatGoldman's Investment Advice Sucks?

The Brown Stinky Stuff is Splattering Off the Fan Blades and Landing on That Shiny New Building on the West Side Highway.

Greece_T_4_0Greece will burn economically because of financially engineered, grifted ways and it most definitely will not be the only country in the EZ to do so. I have made this unequivocally clear since February of 2010, over two years ago - reference the Coming Pan-European Sovereign Debt Crisis.

So who is responsible for such a potentially cataclysmic event and what can be done about it? Well, amazingly, I'll answer it all in one post by combining a little reporting with some hardcore, truly objective, independent financial analysis. Ahhh, I love this new media blogging thingy! From Bloomberg:

Goldman Secret Greece Loan Reveals Two Sinners

Greece’s secret loan from Goldman Sachs Group Inc. (GS) was a costly mistake from the start.

You know, one sentence into this Bloomberg piece it already smacks of realism simply by indicating it was a mistake for an unsophisticated party to do business with Goldman. It's a damn shame that such a statement can be so believable on its face without even an ounce of justification provided yet. It goes to show you exactly how many feel, deep down, Goldman actually manages to outperform. It takes money from the foolish, as opposed to earning it by being the so called best of the best. It is the best, but the best had marketing and grifting - not necessarily engineering the best solution for its clients. You see, most of the time the best solution for your clients are antithetical to both your bonus pool and margin expansion.

On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said.

I hate to say it, but if you're foolish enough to listen to the most profitable bank tell you not to say thing to anybody else about said deal, then you may deserve what's coming to you. If there are any sovereigns or any other entities reading this and you find yourself in a similar situation, I suggest you simply contact me. For those who aren't familiar with me and my ability to sniff things such as these out, I urge you to ask the question, Who is Reggie Middleton? I'll independently review the deal for you and give you the T-R-U-T-H! You know, its been a while since I've seen that word in articles such as these. Another damn shame. There should be plenty of opportunity for me to discuss this, for Greece is definitely not the only European entity to be diagnosed with a chronic case of Goldman's financially engineered derivative product indigestion, reference Smoking Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!  So, I'll be looking forward to hearing from, and visiting you France, Spain, Italy, Portugal, Ireland, Belgium...

Papanicolaou and his predecessor, Christoforos Sardelis, revealing details for the first time of a contract that helped Greece mask its growing sovereign debt to meet European Union requirements, said the country didn’t understand what it was buying and was ill-equipped to judge the risks or costs.

“The Goldman Sachs deal is a very sexy story between two sinners,” Sardelis, who oversaw the swap as head of Greece’s Public Debt Management Agency from 1999 through 2004, said in an interview.

Righhhhht!!! Two sinners... How about an orgy in an economic brothel where financial syphilis was being passed around by the pimp who told all of the excited teenage boys who were about to get their cherry popped that they didn't need condoms, those little rubber things were for wimps. BTW, those pimply faced teenage boys who were convinced to get down without their intellectual/economic prophylactics had a much more diverse selection of accents than this story may lead one to believe - as excerpted from Smoking Swap Guns...

france_telecomm_transaction.png

Moreover, one of the key reasons why such manipulations continued is the apparent ignorance of the EU's Eurostat, which knew enough about these deals to tighten the rules governing their accounting-albeit only after they had served their purpose - the Ponzi! When Italy's then-Prime Minister Romano Prodi miraculously achieved a four-percentage-point improvement in Italy's budget deficit in time to usher the country into the common currency, Italy's use of accounting gimmicks was widely discussed, and then promptly ignored. As at that time, everyone was only too eager to look the other way in the drive to get the single currency up and running.

It wasn't until 2008-a decade after the deals became popular-that Eurostat was able to revise its rules to push countries to include swaps in their debt and deficit calculations. Still, till date too little is known about countries' continued exposure to the deals that are already out there.

Overall, though there is less evidence to support that there are more such swap deals that happened during the late 90's till early part of this decade, the data below showing a sharp decline in interest payments as a percentage of GDP particularly for Belgium (apart from Greece and Italy), hints that there are considerably more of these deals to be discovered. The questions is, will they be discovered before or after the respective sovereign issues record debt to the suckers sovereign fixed income investors.

euro_interest_payments__too_good_to_be_ture.pnge

Notice the extremely supercalifragilisticexpealidocious reductions Belgium, Greece and Italy have made in their interest payments from 1993 to 2000 in this graphic made pre-2000. If one didn't know better, one would have thought theses countries actually used magic to make such reductions. Italy practically cut their debt service (projected, of course) in half. It really makes one wonder. I'm just saying...

BoomBustBlog subscribers (click here to subscribe) are welcome to download our contagion models which have been quite accurate thus far in mapping out where this has, and quite likely will lead us.

• Sovereign Contagion Model - Retail (961.43 kB 2010-05-04 12:32:46)
• Sovereign Contagion Model - Pro & Institutional

In Contagion Should Be The MSM Word Du Jour, Not Bailouts and Definitely Not Greece! I included sample output from the Model detailing the various paths of contagion that can be taken given default by "XYZ" country..

thumb_Sovereign_Contagion_Model_-_Pro__Institutional_demonstration_of_Greek_default

And back to the Bloomberg article...

Goldman Sachs’s instant gain on the transaction illustrates the dangers to clients who engage in complex, tailored trades that lack comparable market prices and whose fees aren’t disclosed. Harvard University, Alabama’s Jefferson County and the German city of Pforzheim all have found themselves on the losing end of the one-of-a-kind private deals typically pitched to them by securities firms as means to improve their finances.

Goldman Sachs DNA

“Like the municipalities, Greece is just another example of a poorly governed client that got taken apart,” Satyajit Das, a risk consultant and author of “Extreme Money: Masters of the Universe and the Cult of Risk,” said in a phone interview. “These trades are structured not to be unwound, and Goldman is ruthless about ensuring that its interests aren't compromised -- it’s part of the DNA of that organization.”

Nawwww!!!  It can't be! Say it "Ain't True!" For those who haven't seen this VPRO special on how Goldman Sachs looted European countries years ago, it is literally a must see. The mayor of a small Italian village speaks candidly and openly to the audience. All it really takes is to hear it from the horse's mouth. If that's not good enough, you can always hear my 15 minute contribution, or that of Simon Johnson, or even Matt Taibbi. Yes, it's all here, complete with English translations where necessary.

A gain of 600 million euros represents about 12 percent of the $6.35 billion in revenue Goldman Sachs reported for trading and principal investments in 2001, a business segment that includes the bank’s fixed-income, currencies and commodities division, which arranged the trade and posted record sales that year. The unit, then run by Lloyd C. Blankfein, 57, now the New York-based bank’s chairman and chief executive officer, also went on to post record quarterly revenue the following year.

So Greece helped "grease' the FICC bonus pool under Lord Lloyd, eventually catapulting him up to the CEO position. Hmmm... Of course, you don't get something for nothing. Methinks Goldman et. al. may have a couple of bones stuffed up into thier closet as well. Speaking of FICC, reference this excerpt from So, When Does 3+5=4? When You Aggregate A Bunch Of Risky Banks & Then Pretend That You Didn't?...

Banks exposure to interest rate and foreign exchange contracts

With volatility in currency markets exploding to astounding levels (with average EUR-USD volatility of 16.5% over the past year (September 2008-09) compared to 8.9%  over the previous year), commercial and investment banks trading revenues are expected to remain highly unpredictable. This, coupled with huge Forex and Interest rate derivative exposure for major commercial banks, could trigger a wave of losses in the event of significant market disruptions - or a race to the exit door of this speculative carry trade. Additionally most of these Forex and Interest rate contracts are over-the-contract (OTC) contracts with 96.2% of total derivative contracts being traded as OTC. This means no central clearing, no standardization in contracts, the potential for extreme opacity in pricing, diversity in valuation as well as a dearth of liquidity when it is most needed - at the time when everyone is looking to exit. Goldman Sachs has the largest OTC traded contracts with 98.5% of its derivative contracts traded over the counter. With the 5 largest banks representing 97% of the total banking industry notional amount of derivatives and most of these contracts being traded off exchange, the effectiveness of derivatives as a hedging instrument raises serious questions since most of these banks are counterparty to one another in one very small, very tight circle (see the free article, "As the markets climb on top of one big, incestuous pool of concentrated risk... ").

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The table below compares interest rate contracts and foreign exchange contracts for JPM, GS, Citi, BAC and WFC.

JP Morgan has the largest exposure in terms of notional value with $64,604 trillion of notional value of interest rate contracts and $6,977 trillion of notional value of foreign exchange contracts. In terms of actual risk exposure measured by gross derivative exposure before netting of counterparties, JP Morgan with $1,798 bn of gross derivative receivable, or 21.7x of tangible equity, has the largest gross derivative risk exposure followed by Bank of America ($1,760 bn, or 18.1x). Bank of America with $1,393 bn of gross derivatives relating to interest rate has the highest exposure towards interest rate sensitivity while JP Morgan with $154 bn of Foreign exchange contracts has the highest exposure from currency volatility. We have explored this in forensic detail for subscribers, and have offered a free preview for visitors to the blog: (JPM Public Excerpt of Forensic Analysis Subscription 2009-09-18 00:56:22 488.64 Kb), which is free to download, and JPM Report (Subscription-only) Final - Professional, or JPM Forensic Report (Subscription-only) Final- Retail as well as a free blog article on BAC off balance sheet exposure If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 3 - BAC).

bank_ficc_otc_exposure_jpm.png

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Cute graphic above, eh? There is plenty of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don't we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman ("Is Lehman really a lemming in disguise?": On February 20th, 2008) months before their collapse by taking a close, unbiased look at their balance sheet.

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Subscribers, see WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb, ~ WFC Off Balance Sheet Exposure 2009-10-19 04:25:53 258.77 Kb ~ WFC Investment Note 22 May 09 - Retail 2009-05-27 01:55:50 554.15 Kb ~ WFC Investment Note 22 May 09 - Pro 2009-05-27 01:56:54 853.53 Kb ~ Wells Fargo ABS Inventory 2008-08-30 06:40:27 798.22 Kb

Of course, this article is about Goldman right? In addition, exposure doesn't necessarily mean that the  shit will it the fan, right? After all, it's different this time!!!

The interest rate storm is coming, that is unless Europe can maintain historically low rates as several countries default. Then again, they never default, right...

Don't believe me, let's look at history...

Again, click the little pics to make big pics...

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So, as I was saying...

Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?

Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?

Goldman is much more highly leveraged into the derivatives trade than ANY and ALL of its peers as to actually be difficult to chart. That stalk representing Goldman's risk relative to EVERY OTHER banks is damn near phallic in stature!

Click those little pictures to make BIG pictures....

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As opined earlier through the links "The Next Step in the Bank Implosion Cycle???"and As the markets climb on top of one big, incestuous pool of concentrated risk... , this is not a new phenomenon. Quite to the contrary, it has been a constant trend through the bubble, and amazingly enough even through the crash as banks have actually ratcheted up risk and assets in a blind race to become TBTF (to big to fail), under the auspices of the regulatory capture (see Lehman Dies While Getting Away With Murder: Introducing Regulatory Capture). So, what is the logical conclusion? More phallic looking charts of blatant, unbridled, and from a realistic perspective, unhedged RISK starring none other than Goldman Sachs...

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And to think, many thought that JPM exposure vs World GDP chart was provocative. I query thee, exactly how will GS put a real workable hedge, a counterparty risk mitigating prophylactic if you will, over that big green stalk that is representative of Total Credit Exposure to Risk Based Capital? Short answer, Goldman may very well be to big for a counterparty condom. If that's truly the case, all of you pretty, brand name Goldman counterparties out there (and yes, there are a lot of y'all - GS really gets around), expect to get burned at the culmination of that French banking party I've been talking about for the last few quarters. Oh yeah, that perpetually printing clinic also known as the Federal Reserve just might be running a little low on that cheap liquidity antibiotic... Just giving y'all a heads up ahead of time...

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... I'd like to announce to the release of a blockbuster document describing the true nature of Goldman Sachs, a description that you will find no where else. It's chocked full of many interesting tidbits, and for those who found "The French Government Creates A Bank Run? Here I Prove A Run On A French Bank Is Justified And Likely" to be an iteresting read, you're gonna just love this! Subscribers can access the document here:

• Goldman Sachs Q3 Forensic Review - Retail
• Goldman Sachs Q3 Forensic Review - Professional

Okay, now back to that Bloomberg article...

‘Extremely Profitable’

The Goldman Sachs transaction swapped debt issued by Greece in dollars and yen for euros using an historical exchange rate, a mechanism that implied a reduction in debt, Sardelis said. It also used an off-market interest-rate swap to repay the loan. Those swaps allow counterparties to exchange two forms of interest payment, such as fixed or floating rates, referenced to a notional amount of debt.

The trading costs on the swap rose because the deal had a notional value of more than 15 billion euros, more than the amount of the loan itself, said a former Greek official with knowledge of the transaction who asked not to be identified because the pricing was private. The size and complexity of the deal meant that Goldman Sachs charged proportionately higher trading fees than for deals of a more standard size and structure, he said.

“It looks like an extremely profitable transaction for Goldman,” said Saul Haydon Rowe, a partner in Devon Capital LLP, a London-based firm that advises global investors on derivatives disputes.

Disappearing Debt

Goldman Sachs declined to comment about how much it made on the swaps. Fiona Laffan, a spokeswoman for the firm in London, said the agreements were executed in accordance with guidelines provided by Eurostat, the EU’s statistical agency.

Oh yeah, Eurostat! That bastion of Eurofellas who really, really know what they're talking about - as evidenced from Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!

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Revisions-R-US!

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and the EU on goverment balance??? Way, way, way off.

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“Greece actually executed the swap transactions to reduce its debt-to-gross-domestic-product ratio because all member states were required by the Maastricht Treaty to show an improvement in their public finances,” Laffan said in an e- mail. “The swaps were one of several techniques that many European governments used to meet the terms of the treaty.”

Cross-currency swaps are contracts borrowers use to convert foreign currency debt into a domestic-currency obligation using the market exchange rate. As first reported in 2003, Goldman Sachs used a fictitious, historical exchange rate in the swaps to make about 2 percent of Greece’s debt disappear from its national accounts. To repay the 2.8 billion euros it borrowed from the bank, Greece entered into a separate swap contract tied to interest-rate swings.

Falling bond yields caused that bet to sour, and tweaks to the deal failed to prevent the debt from almost doubling in size by the time the swap was restructured in August 2005.

Greece, which last month secured a second, 130 billion-euro bailout, is sitting on debt equal to about 160 percent of its GDP as of last year...

‘Teaser Rate’

The derivative Loudiadis offered Sardelis in 2001 was also complex. Designed to provide a cheap way to repay 2.8 billion euros, the swap had a “teaser rate,” or a three-year grace period, after which Greece would have 15 years to repay Goldman Sachs, Sardelis said. All in, the deal appeared cheap to officials at the time, he said.

“We calculated that this had an extra cost above our normal funding cost on the yield curve of 15 basis points,” Sardelis said....

‘Very Bad Bet’

Sardelis said he realized three months after the deal was signed that it was more complex than he appreciated. After the Sept. 11, 2001, attacks on the U.S., bond yields plunged as stock markets sold off worldwide. That caused a mark-to-market loss on the swap for Greece because of the formula used by Goldman Sachs to compute Greece’s repayments over time.

“If you calculated that when we did it, it looked very nice because the yield curve had a certain shape,” Sardelis said. “But after Sept. 11, we realized this would be the wrong formula. So after we discussed it with Goldman Sachs, we decided to change to a simpler formula.”

The revised deal proposed by the bank and executed in 2002, was to base repayments on what was then a new kind of derivative -- an inflation swap linked to the euro-area harmonized index of consumer prices. An inflation swap is a financial bet that pays off according to the degree to which a consumer-price index exceeds or falls short of a pre-specified level at maturity.

That didn’t work out well for Greece either. Bond yields fell, pushing the government’s losses to 5.1 billion euros, according to an analysis commissioned by Papanicolaou. It was “a very bad bet,” he said in an interview.

“This is even more reprehensible,” Papanicolaou said of the revised deal. “Goldman asked them to make a change that actually made things even worse because they went into an inflation swap.”

And what the hell were they expecting? Didn't they realize that it was Goldman that was on the other side of the swap? Do you expect a wolf to turn down a pound of meat if he is asked if he wants it?

Confidentiality Requirement

Greece was handicapped, in part, by the terms Goldman Sachs imposed, he said.

“Sardelis couldn’t actually do what every debt manager should do when offered something, which is go to the market to check the price,” said Papanicolaou, who retired in 2010. “He didn’t do that because he was told by Goldman that if he did that, the deal is off.”

Sardelis declined to comment about the analysis, as did Petros Christodoulou, director general of the debt-management agency since February 2010.

It isn’t unusual for dealers to impose confidentiality requirements on clients in complex transactions to prevent traders from using the information to front-run or trade against the bank arranging and hedging the deal, said a former official who analyzed the swap and asked not to be named because the details are private.

Personally, I dont care if it isn't unusual to impose confidentiality on complex deals. If you don't understand the deal, seek qualified, impartial assistance. If you're counterparty doesn't like that, then ever so politely tell them to f@ck off - PERIOD! If you enter into a deal that you don't understand, don't be surprised from that itchy/burning/stretched feeling you're bound to feel in your anus a few months into the deal.

‘Large Number’

Goldman Sachs’s initial 600 million-euro gross profit “sounds like a large number, but you have to take into account what the bank will be setting aside as a credit reserve, the cost to Goldman to fund the loan and the cost of hedging the currency component,” said Peter Shapiro, managing director of Swap Financial Group LLC in South Orange, New Jersey, an independent swaps adviser. “It’s hard to tell what the profit margin would have been.”

Hmmmm... Methinks I could tell that it would have been a lot higher than a plain vanilla loan's profit margin at prevailing rates, no?

The report Papanicolaou commissioned after taking over the agency showed the repayment formula meant that Greece would have to pay Goldman Sachs 400 million euros a year, he said. The coupon and the mark-to-market swings on the swap prompted George Alogoskoufis, then finance minister, to decide to restructure the deal again to limit losses, Papanicolaou said.

Loudiadis and a team of Goldman Sachs advisers returned to Athens in August 2005, according to former Greek officials. The agreement they reached to transfer the swap to National Bank of Greece SA and extend the maturity to 2037 from 2019, gave the Greeks what they wanted, Papanicolaou said.

Oh yeah! That ever so solvent bastion of Greco-intellectual economic capability that I warned about two years ago, see How Greece Killed Its Own Banks! and the Greek Banking Fundamental Tear Sheet.

‘Squeeze Taxpayers’

The 5.1 billion-euro mark-to-market value of the swap was “locked in,” Papanicolaou said. It was that politically motivated decision to restructure and fix the increased market value that did as much damage as the original swap, said Sardelis, now a board member of Ethniki General Insurance Co., a subsidiary of National Bank of Greece.

“You can’t have prudent debt management if you change all the assumptions all the time,” he said.

Gustavo Piga, a professor of economics at University of Rome Tor Vergata and author of “Derivatives and Public Debt Management,” sees a different lesson.

“In secret deals, intermediaries have the upper hand and use it to squeeze taxpayers,” Piga said in an interview. “The bargaining power is in investment banks’ hands.”

Professor Gustavo Piga is the esteemed fellow who offered the nuggets of wisdom in the VPRO video above.

The nitty gritty on Goldman Sachs that you just won't get anywhere else...

If you haven't already, please do review the first four parts of this series, and if so skip past this break and into the nitty gritty--->

I'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & IntroductionI'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & Introduction	I'm Hunting Big Game Today: The Squid On A Spear Tip Summary: This is the first in a series of articles to be released this weekend concerning Goldman Sachs, the Squid! In this introduction (for those who do not regularly follow me) I demonstrate how the market, the sell side, and most investors are missing one of the biggest bastions of risk in the US investment banking industry. I will also...
Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?	Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored? Welcome to part two of my series on Hunting the Squid, the overvaluation and under-appreciation of the risks that is Goldman Sachs. Since this highly analytical, but poignant diatribe covers a lot of material, it's imperative that those who have not done so review part 1 of this series, I'm Hunting Big Game Today:The Squid On The Spear Tip, Part...
Reggie Middleton Serves Up Fried Calamari From Raw Squid: Goldman Sachs and Market Perception of Real Risks!Reggie Middleton Serves Up Fried Calamari From Raw Squid: Goldman Sachs and Market Perception of Real Risks!	Hunting the Squid Part 3: Reggie Middleton Serves Up Fried Calamari From Raw Squid For those who don't subscribe to BoomBustblog, or haven't read I'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & Introduction and Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?, not only have you missed out on some unique artwork, you've potentially missed out on 300%...
Hunting the Squid, part 4: So, What Else Can Go Wrong With The Squid? Plenty!!!Hunting the Squid, part 4: So, What Else Can Go Wrong With The Squid? Plenty!!!	Hunting the Squid, part 4: So, What Else Can Go Wrong With Goldman Sachs? Plenty! Yes, this more of the hardest hitting investment banking research available focusing on Goldman Sachs (the Squid), but before you go on, be sure you have read parts 1.2. and 3:  I'm Hunting Big Game Today:The Squid On A Spear Tip, Part 1 & Introduction Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To...

Hunting the Squid, Part 5: Sometimes Your Local Superhero Doesn't Look Like What They Show You In The Movies 

What Was That I Heard About Squids Raising Capital Because They Can't Trade?

Reggie Middleton vs the Squid That Can't Trade!

A Few Quick Comments On Goldman's Q4 2011 ... - BoomBustBlog

Reggie Middleton on Realism and being Offensively Honest

The many ways to reach Reggie Middleton:

Or simply email me.

I am working on an interesting project closely connected to the issue that European (and now American) banks are facing. The firs of several reports should be available to paid subscribers in about a week. In the meantime, let's make a few observations that may or may not have been lost on market participants.

Paid subscribers should reference the quarterly results of the bank that was illustrated in our most recent forensic report - Haircuts, Derivative Risks and Valuation. Yes, BoomBustBlog has hit the skin off the ball once again. I will be available in the private forums to discuss this, as well as provide links for those who have not seen the news yet.

Summary: For years I have warned of the impending European collapse. Now, as it is happening, we still have banks getting away with nonsensical 60% writedowns on essentially worthless debt. Loss Given Default > 100+% - You ain't seen the worst of it, not by a long shot!

From the BNP Paribas earnings press release:

Rather than implementing the agreement reached on 21 July, EU authorities formulated a new Greek assistance package on 27 October. As a result of this plan, whose implementation is still shrouded by uncertainty, BNP Paribas set aside a provision for 60% of the full amount of all Greek sovereign debt it holds, which equates to further provision of 2,094 million euros for the banking book and of 47 million euros for the insurance portfolio. Furthermore, the effect of the additional impairment of Greek bonds on associated companies was negative to the tune of 116 million euros.

The Group's revenues, which totalled 10,032 million euros, were down 7.6% compared to the third quarter 2010. They grew in Retail Banking (+2.2% at constant scope and exchange rates with 100% of the domestic networks' private banking businesses, excluding PEL/CEL effects), and Investment Solutions (+2.5%) but fell 39.8% at Corporate and Investment Banking due to very challenging market conditions and losses on sales of sovereign bond debt (-362 million euros). Corporate Centre revenues were affected by two exceptional items related to the valuing of long-term assets and liabilities at market price (+786 million euros in own debt revaluation and -299 million euros in additional impairment on the equity investment in AXA).

This seems to be glossed over, but the equity impairments and revaluation of liabilities are a big deal, particularly in entities that are bond rich (well, now poor).

... With the additional provision set aside for Greek government bonds, the cost of risk was 3,010 million euros.

Excluding this effect, it continued its downward trend (-28.9%) in all the business units, coming in at 869 million euros, or 50 basis points of outstanding customer loans compared to 72 basis points in the third quarter 2010.

This is nonsense. They are speaking as if the devaluation is a one time event, when in reality it is the beginning of a long string of events. You lose credibility when you play your audience for fools...

The Group reported 541 million euros in net profits (attributable to equity holders) (-71.6% compared to the third quarter 2010). Excluding the Greek debt provision, net profits were 1,952 million euros, up 2.4% compared to the same period a year earlier.

For the first nine months of the year, the Group's revenues totalled 32,698 million euros, a limited decline compared to the first nine months of 2010 (-2.6%). Thanks to CIB's flexible costs, and despite the effect of the bank levies, operating expenses edged down 1.0% (-1.7% excluding the bank levies). Gross operating income was down 4.8% at 13,260 million euros and net income (attributable to equity holders) down 16.0% at 5,285 million euros. Excluding the impact of the provision set aside in connection with the Greek assistance programme, the cost of risk was down 28.5% during the period and net income (attributable to equity holders) totalled 7,034 million euros, up +11.8% compared to the first nine months of 2010.

Click to expand...

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But including losses on Spanish, Italian, Irish and Portuguese capital losses realized upon disposition, and the ongoing losses on Greek debt, what then????

You see, the truly under appreciate problem here is that the private banks rampant selling is driving down the prices of already highly distressed and rapidly devaluing bonds. Reference Bloomberg's European Banks Selling Sovereign Bond Holdings Threatens to Worsen Crisis.

In the news now, exactly as I anticipated European Stocks Drop as Italian Bond Yields Jump as well as:

No surprises here:Wednesday, 03 August 2011 - France, As Most Susceptble To Contagion, Will See Its Banks Suffer

These events are quite relevant for I warned several times over that the true risks are in Italy's funding fragility, its size, and its direct ties into France who, if caught the contagion, would invalidate any Pan-European rescue scheme. That is why "The French Banks Are The First To Accept a Voluntary Greek Restructuring". Well, here we are! Another point that is oft overlooked is that while all of the these private holders are dumping European bonds en mass, who is buying them. Well, I addressed this last year and early this year as well.. Over A Year After Being Dismissed As Sensationalist For Questioning the ECB's Continued Solvency After Sovereign Debt Buying Binge, Guess What! Keep in mind that Italy has already accepted IMF supervision over its finances, which means that it has in essence already given up its sovereign financial independence. We all know what the next step is, don't we? The IMF injects funds under strict austerity and calls the shots, just like it does with (other?) third world nations. There are ramifications here that are simply lost on most, but I will help most find it! Please continue reading...

The ECB as well as many local banks and pension schemes are being forced to buy these bonds to maintain a facade of a bid in a near bidless market (at least bidless from the perspective of avoiding total price collapse), but what does that portend for the entities doing the buying if the sellers are losing so much money and the yields are still flying through the roof? Well I addressed that in early 2010, reference  How Greece Killed Its Own Banks!.

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Yes, it's ugly, and it gets even uglier! Nouriel Roubini Tweets this morning "Italian yields at Ponzi levels: having to borrow more just to finance the interest on debt leading to vicious unsustainable debt dynamics." I respect this man's opinion, but he is just scraping the surface. Look back to last year when I really started bringing up the case of defaults, liquidations and recoveries in the iconic piece How the US Has Perfected the Use of Economic Imperialism. Warning, this is going to piss off many an oligarch! As excerpted...

How many of those Greek, Portuguese, Irish and Spanish bondholders have factored the near guaranteed "additional" haircut (/scalping) they will receive having to stand behind the IMF in the event of a (probably guaranteed) default or restructuring? Do you think the investors of European banks (that includes central banks) that are holding/and currently still buying a boat load of these bonds have factored this into their valuations?

The IMF, like many other international institutions, asserts that it has a "preferred creditor status", and this has been a practiced convention in the past. Thus, IMF has de facto seniority rights over private creditors despite the fact that there is no legal or treaty-based foundation to support this claim and this seniority of rights for IMF will continue under the recent EU rescue plan announced as well as it has not been noted otherwise implicitly nor explicitly. This is the reason why Sarkozy said it is a said day when the EU has to accept a bailout from the IMF (aka, the US). The EU now, and truly, contains a significant parcel of debtor nations.

To add fuel to this global macro tabloidal fire, the Euro members’ loan will be pari passu with existing sovereign debt i.e. it will not be considered senior. Although there is no written, hard evidence to support this claim, it is our view that otherwise there will be no incentive for investors to hold the debt of troubled countries like Greece, which will ultimately defeat the whole purpose of the rescue package. Moreover, there are indications that support this idea. As per Dutch Finance Minister Jan Kees de Jager, “We are not talking about a special preference for the eurogroup loans, that’s not possible because then you would have the situation that already-existing rights of creditors at the moment would be harmed.” (reference http://www.businessweek.com/news/2010-04-16/netherlands-excludes-senior-status-for-greek-aid-update1-.html). Of course, if more investors did their homework and ran the numbers, that same disincentive can be said to exist with the IMF's super senior preference given the event of a default and recoverable collateral after the IMF has fed at the trough.

The above-referenced article is a must read and an eye-opener to all of those who think that those 60% haircuts that BNP et. al. are taking are anything near sufficient. And on that note, what haircut is sufficient to mark Greek debt to market for these big banks and funds? Stay tuned boys and girls, I answered this question last year...

And in the End, What Does It All Mean?

LGD 100+: What's the Possibility of Certain European Banks Having a Loss Given Default Approaching 100%?

Take note that this update will include several American banks and the risks they face from writing nearly all of the richly priced CDS purchased by said European banks. This is an interesting and complicated story because all of those IMF/EU bailouts, besides adding more debt to already debt laden countries, have considerably subordinated the claims of the stakeholders involved. The following was written over a year ago, and has proven to be quite prescient:

LGD: Loss Given Default... ~100%???

I will have some more goodies along these lines that still HAVE NOT been broached by either the pop media or the sell side for BoomBustBlog subscribers very soon.

Tools for tracking the ever elusive path of contagion for BoomBustBlog subscribers:

• Sovereign Contagion Model - Retail (961.43 kB 2010-05-04 12:32:46)
• Sovereign Contagion Model - Pro & Institutional

 Additional posts on the topic of Bank Runs

1. The Mechanics Behind Setting Up A Potential European Bank Run Trade and European Bank Run Trading Supplement
2. What Happens When That Juggler Gets Clumsy?
3. Let's Walk The Path Of A Potential Pan-European Bank Run, Then Construct Trades To Profit From Such
4. Greece Is Fulfilling Our Predictions Of Default Precisely As Predicted This Time Last Year
5. The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!
6. The Fuel Behind Institutional “Runs on the Bank” Burns Through Europe, Lehman-Style!
7. Multiple Botched and Mismanaged Stress Test Have Created The Makings Of A Pan-European Bank Run
8. Observations Of French Markets From A Trader's Perspective
9. On Your Mark, Get Set, (Bank) Run! The D…

For those who are interested in getting the real nitty gritty, click here to subscribe.

Interested parties can follow and contact me via:

Four months ago, I posted to seminal pieces, namely The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!and The Fuel Behind Institutional “Runs on the Bank” Burns Through Europe, Lehman-Style! that outlined in explicit detail, the path, methodology and cause and effect of bank runs that will emanate from Europe. Any who have not read these two posts, be aware that I consider them a must. For those of you who feel that my posts are too long, I urge you to take the content embedded within them more seiously (both paid and free content), for although verbose, they are proving to be most prescient. 

As excerpted:

Traditional views on this “bank run model” largely (or more aptly, only) consider individual savers in the form of depositors on the short side (liquid liabilities). It is a run such as this that caused the banking collapse during the US Great Depression. The modern central banking system has proven resilient enough to fortify banks against depositor runs, as was recently exemplified in the recent depositor runs on UK, Irish, Portuguese and Greek banks – most of which received relatively little fanfare. Where the risk truly lies in today’s fiat/fractional reserve banking system is the run on counterparties. Today’s global fractional reserve bank get’s more financing from institutional counterparties than any other source save its short term depositors.  In cases of the perception of extreme risk, these counterparties are prone to pull funding are request overcollateralization for said funding. This is what precipitated the collapse of Bear Stearns and Lehman Brothers, the pulling of liquidity by skittish counterparties, and the excessive capital/collateralization calls by other counterparties. Keep in mind that as some counterparties and/or depositors pull liquidity, covenants are tripped that often demand additional capital/collateral/ liquidity be put up by the remaining counterparties, thus daisy-chaining into a modern day run on the bank!

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This phenomena essentially discredits the thinking at large and currently in practice that “since individual expenditure needs are largely uncorrelated, by the law of large numbers” banks should expect few withdrawals on any one day. The fact of the matter is that in times of severe distress, particularly stemming from solvency issues (read directly as the Pan-European Sovereign Debt Crisis, and Greece, et. al. in particular), the exact opposite is the case. Individual depositor and counterparty actions are actually HIGHLY correlated and tend to move in tandem, particularly when that move is out of the target fiat bank. They tend to take heed to the saying “He who panics first, panics best!"

Asset/liability mismatch can, at the margin nearly assure a Lehman-style fiasco in the case of an impetus that sparks herding mentality, whether it be among depositors/savers or institutional counterparties.

So, armed with the cause, effect, and path of bank runs coming from Europe, templated by Lehmand and Bear, guess what happend yesterday? As excerpted from FT.com: MF Global and the repo-to-maturity trade

... So, while most of the media has been commonly referring to MF’s sovereign bond positions as proprietary bets gone wrong, there’s more to it than just that. If anything this was a financing position (or liquidity trade) — not a bet on the future direction of the bonds themselves. What’s more, if executed properly the trade should — at least on paper – have posed little or no risk. The maths was simple enough. You account for the cost of borrowing funds using the bonds in question as collateral (the repo rate) versus the ultimate coupon payments received from the very same bonds.

This is because in dysfunctional markets the repo rate can be out of kilter with the ultimate returns of the bond itself. This is especially the case if there are more counterparties willing to provide short-term liquidity in return for rates that beat the nominal risk-free return.  In other words to act as pawnbrokers to the market. Alternatively, if you have a good credit standing in the market you may be able to achieve a more favourable repo rate than others. If everyone plays their cards right, MF Global receives financing (or liquidity) at a better rate than the market’s –  since they are offsetting the repo charges with the ultimate coupon payments — and the counterparty is rewarded in basis points for holding the bond in the interim.

Gross profit is simply total inflow minus total outflow.

As fixed income guru Moorad Choudhry noted in the “Repo Handbook” such a trade should generally be considered low-risk since the financing profit on the bond position is known with certainty until the bond’s maturity.

...In other words, mark-to-market ought not be a concern. As long as the bond pays out at the price you bought if for (which it will if it is held to maturity), it should not be considered a risky position.

As can be seen from MF Global’s earnings statement, MF was indeed counting on the EFSF guarantee to ensure that this would be the case:

... “Over the course of the past year, we have seen opportunities in short-dated European sovereign credit markets and built a fully financed, laddered maturity portfolio that we actively manage. We remain confident that we have the resources and expertise to continue to successfully manage these exposures to what we believe will be a positive conclusion in December 2012,” Mr. Corzine concluded.

On top of that — just in case an unexpected default risk came its way — MF Global had actually hedged the $6.3bn position with a $1.3bn short French government bond trade.

So what on earth went wrong? Italy and Belgium are, after all, still very unlikely to default before the end of 2012. There is no reason, therefore, why the bonds shouldn’t payout.

Which leaves only the possibility of some skittish repo counterparties suddenly getting cold feet and pulling out (or demanding a greater proportion of over-collateralisation with respect to the loan.

If repo contracts were completely reneged upon, this would not only have left MF with a sudden liquidity issue — especially if they couldn’t find a fresh counterparty — but also with a sudden need to mark-to-market the bonds.

Indeed as Reuters reported on Monday:

Last week, counterparties likely pressed MF Global to post more collateral on derivatives trades and may have started reducing the company’s repo financing lines, market sources said.We’re not sure exactly how easy it is to undo a “repo-to-maturity” trade, but it does leave us wondering who exactly those counterparties might have been.

Update 9.30pm GMT: As Kamekon points out below, in most circumstances — depending on the terms and conditions — repos would be subject to regular margin calls or “loan repayments” which re-establish the original repo ratio. Either way, a fall in the value of the bonds could create a major liquidity drain for MF Global. Though these sorts of liquidity risks should have been accounted for in VaR calculations. Much harder to anticipate would have been a complete disappearance of willing counterparties.

So there you go. The MF Global collapse was fueled (ironically) by ZIRP as clearly predicted here The Ironic, Prophetic Nature of the MF Global Bankruptcy Filing and It's Potential Ramifications, and the straw that broke the camel'sman's back was an old fashioned institutional bank run, as was clearly anticipated many months ago here at BoomBustBlog.

Subscribers, this distrust, collateral calling, back stabbing bank run thing will get much worse before it gets better. I strive to put out quality, not quantity, and I truly believe that those banks and entities outlined in the research reports of the past two months are going to prove to be blockbusters of alpha on the short side. Reference the Commercial & Investment Banks subcategory under "Banks & Financial Services" heading in the subscription content tab. The last three entities covered are again ripe for the picking after the recent bear rally, in the case of a systemic downturn (which I fully anticipate) although I can't guarantee for how long.

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The following is an excerpt of emails allegedly showing Bank of America employees purposely removing, falsifying and electronically altering loan documents. It was taken from Bank of America Sucks site, which is affiliated with Anonymous, a hacker group sympathetic with Wikileaks. This is apparently part on in a multi-part installment. I will leave it up to the readers to judge the veracity and weight of what is presented. Be aware that these emails were dated just four months ago. That means that these shenanigans are being performed very, very recently and under the watch of the new CEO. Ken Lewis was canned for allegedly not running a tight ship, but this is the bank that bought Countrywide, and Countrywide is literally a litigation sinkhole. As you can see, there are probably several follow-up email sessions to come.

My name is (Anonymous). For the last 7 years, I worked in the Insurance/Mortgage industry for a company called Balboa Insurance. Many of you do not know who Balboa Insurance Group (soon to be rebranded as QBE First by Australian Reinsurance Company QBE according to internal communication sent to all Balboa associates) is, but if you’ve ever had a loan for an automobile, farm equipment, mobile home, or residential or commercial property, we knew you. In fact, we probably charged you money…a lot of money…for insurance you didn’t even need.

Balboa Insurance Group, and it’s largest competitor, the market leader Assurant, is in the business of insurance tracking and Force Placed Insurance (aka Lender Placed Insurance, FOH, LPI, etc). What this means is that when you sign your name on the dotted line for your loan, the lienholder has certain insurance requirements that must be met for the life of the lien. Your lender (including, amongst others, GMAC, Aurora Loan Services [a subsidiary of Lehman Bros Holdings], IndyMac Federal Bank [a subsidiary of OneWest Bank], Saxon, HSBC, PennyMac [a collection agency started by former Countrywide Home Loans executive Stan Kurland after CHL and Balboa were sold to BAC], Downey Savings and Loans, Financial Freedom, Select Portfolio Services, Wells Fargo/Wachovia, and the now former owners of Balboa Insurance themselves…Bank of America) then outsources the tracking of your loan with them to a company like Balboa Insurance.

Balboa makes some money by charging these companies to track your insurance (the payment of which is factored into your loan). If you do not meet the minimum insurance requirements set by your lienholder, Balboa Insurance places a force placed insurance policy on your loan. You are sent a letter telling you that you do not have insurance, and your escrow account is then adjusted for the inflated premium of a full coverage policy placed by Balboa’s insurance tracking group, run by Steven Ramsthel, Sr Vice President of Loan Tracking Operations & Customer Care at Balboa Insurance Group, as seen on his LinkedIn profile below: