I have some very interesting stuff coming up that is the result of my following the breadcrumbs of the banking system liabilities. I think it should be educational, but won't be out till later today or tomorrow.

Next week I will focus on publishing the tweaks I made to my market neutral investing models which now automatically search out the most liquid, under priced opportunities taken into consideration open interest, spreads, and theoretical>market pricing in real time for up to 1,000 option contracts [typo, corrected] at a time. I will be offering this to all paying subscribers again (this time), but will eventually will be a pro service only. The goal is to hammer out a market neutral program that makes money in the bear rally, but will really be able to take advantage of the inevitable market drop. The market neutral program put out 20% for the month of September, while still offering bearish exposure.

I would like to use the comments section for this post as open discussion. It was interesting to note readers speculating on going bullish on the dollar, then watching the dollar rally to a two month high overnight. Any more thoughts on things macro, micro or otherwise are welcome.

The market neutral option strategies analyzed and made available for download last quarter have effectively accomplished their mission, namely allowing one to maintain a bearish position while still being able to profit from spikes in the market. In periods of uncertainty, this is the methodology that I will fall back on personally, although the directional positions are the ones that reap my windfall profits.

The following are the updated payoff's for selected optimal strategies for rhe S&P index, GS, JPM, AXP, HOT, STI, CAT and MAC (subscribers, see the downloads section for the strategies and the forensic analysis of each company). We have computed revised breakeven points, initial cost, payoff matrix, implied volatility and option parameter for the optimal strategies selected previously. I will post these figures in detail within 24 hours, but here is the synopsis.

JPM derivative and off balance sheet lending commitments and guarantees exposure

Warning!!! This is the type of investigative, unbiased and independent analysis that you will never find in the mainstream media. Long live the Blogoshpere!!!

As we step through the various exposures that this most esteemed bank has, keep in mind that as of June 30, 2009 JPM's common shareholder's equity and tangible common equity stood at $147 bn and $79 bn, respectively. You tell me if the risk inherent in our banking system has been mitigated, please!

Off balance sheet lending commitments and guarantees

As of June 30, 2009, JPM had exposure of $85 billion (or 108% of its tangible equity) towards off balance sheet lending commitments and guarantees. The contractual amount of the off balance sheet lending commitments and guarantees represents the maximum possible credit risk should the counterparty draw upon the commitment or JPM be required to fulfill its obligation under the guarantee, and the counterparty subsequently fail to perform according to the terms of the contract.

Early in 2008 I named Morgan Stanley the "The Riskiest Bank on the Street" (see historical links at the bottom of this article). Well, now its time to update my opinion. Who deserves the title "The Riskiest Bank on the Street" now? Well, let's see what the market says...

As defined by Wikipedia: Cost of Captial - Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.

This means that one should not simply glance at accounting earnings and declare all is clear on the western front. Whatever return your company generates has to exceed the cost of investing in said company. Well, of the bulge bracket, who has the highest cost of capital? Who has the highest bar? Who does the Street see as the Riskiest Bank on the Street?

cost_of_capital.png

Well it seems as if the company that had the highest cost of capital apparently had enough risk to actually implode. Is there a pattern here? If so, I must be the only one that recognizes it because the current number one spot (the graphed number one spot already collapsed) traded over $130 per share last week.

For those that don't believe in Cost of Capital in measuring risk, I bring you to another metric. As defined by Wikipedia: Leverage (or gearing due to its analogy with a gearbox) is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced.^[1] It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. Deleveraging is the action of reducing borrowings.^[1]

Financial leverage

Financial leverage (FL) takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets (ROA) is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow because assets = equity + debt (see accounting equation). On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor that otherwise would have been unavailable but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying is a common way of utilizing the concept of leverage in investing. An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firm is made up of ownership equity and debt. A firm's debt to equity ratio is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem. As is true of operating leverage, the degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (earnings per share) that occurs as a result of a percentage change in earnings before interest and taxes.

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Derivatives

Derivatives allow leverage without borrowing explicitly, though the "effect" of borrowing is implicit in the cost of the derivative.

• Buying a futures contract magnifies your exposure with little money down.
• Options do the same. The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument. Generally speaking, a put option allows the holder (owner), the investor, to achieve inverted-leverage and/or inverted enhancement--- sometimes called inverse enhancement and/or inverse leverage.
• Structured products that exist as either closed-ended funds, or public companies, or income trusts are responding to the public's demand for yield by leveraging. That's a good idea. Let's refer to Goldman Sachs as a Structured Product!

Risk and overleverage

Employing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Interest and principal payments (usually certain ex-ante) may be higher than the investment returns (which are uncertain ex-ante).

This increased risk may still lead to the optimal outcome for the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and security purchases, is the subject of a discipline known as financial engineering.

There are economic periods when optimism incites to a widespread and excessive use of leverage, what is called overleverage. One of its forms, associated to the subprime crisis, was the practice of financing homes with no or little down payment, playing on the hope that the price of the assets (the property in this case) will rise. Another form involved the five largest U.S. investment banks, which borrowed funds to invest in mortgage-backed securities, increasing their leverage between 2003-2007 (see diagram). During September 2008, the five largest firms either went bankrupt (Lehman Brothers), were bought out by other banks (Merrill Lynch and Bear Stearns) or changed to commercial bank holding companies, subjecting themselves to leverage restrictions (Morgan Stanley and Goldman Sachs).

Well, on the topic of leverage, who do you think is the most leveraged bank? Notice that these leverage ratios below are unadjusted. That means that they will go up significantly if I took the time to extract the accounting shenanigan trash that is used to give the impression of lower leverage (this adjustment is explictly done in the 131 page Goldman Sachs Professional Stress Test).

newestriskiestbank.gif

Notice that although Goldman Sachs is the leveraged risk winner as of now, but they would have probably been beaten by Merrill Lynch. Hey, where is Merrill Lynch by the way? You know, it can get pretty painful for guys to play hide the "leveraged" sausage. If you know what I mean...

Okay, for you real stubborn guys and gals who don't think the cost of capital or leverage are legitmate determinants of risk, let's take a look at other popular risk metrics. Surely they will vindicate the riskiest bank on the Street, right? Below, please find the Goldman Sachs VaR and Risk Adjusted Return on Risk Adjusted Capital Chart.

varrarorc.gif

Now, as we can plainly see, Goldman Sachs has steadily trended down in its RARORAC and steadily trended higher in VaR. In other words, risk has steadily increased as risk adjusted return has steadily decreased.

For those who feel I am simply blogging in sanscrit, let's pull up the Wikipedia definitions for VaR and RARORAC:

Value at Risk (VaR):

In financial mathematics and financial risk management, Value at Risk (VaR) is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.^[1]

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds the VaR threshold is termed a “VaR break.”^[2]

The 10% Value at Risk of a normally distributed portfolio

VaR has five main uses in finance: risk management, risk measurement, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well.^[3]

Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust in the late 1970s. Note, however, that more and more Risk Adjusted Return on Risk Adjusted Capital (RARORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel II.

...

Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, that is it is a buffer against heavy shocks. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.

RAROC system allocates capital for 2 basic reasons:

1. Risk management
2. Performance evaluation

For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure—that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit.

Now that we're all up to speed, let's take this one step farther. Below you may find the One-Day Trading VaR of GS with a 95% confidence level.

dailytradingvar.gif

Here we find proof that Goldman Sachs has indeed usurped Morgan Stanley for the title of "Riskiest Bank on the Street".

daysexceedingvar.png

Hey, notice how Goldman Sachs has trended DOWNWARD regularly and steadily over the one year period. As a matter of fact, the only company that had a lower risk adjusted capital return was Lehman. So let's compare what is happening now... Oh yeah, we can't because Lehman has already collapsed. What does that portend for Goldman who appears to operate quite similarly?

raroc.png

I know many of you new readers are wondering, "Who the hell is this guy?". Well, this guy is someone who has been pretty good at ferreting out weak companies on the verge of collapse:

There is the call of the fall of REITs and commercial real estate in 2007 - "GGP has finally filed Bankruptcy, Proving My Analysis to be On Point Over the Course of 18 Months". I also called Bear Stearns (Is this the Breaking of the Bear? [Sunday, 27 January 2008]), Lehman Brothers CRE implosion connection (Is Lehman really a lemming in disguise? [Thursday, 21 February 2008]), Countrywide and Washington Mutual (Yeah, Countrywide is pretty bad, but it ain’t the only one at the subprime party… Comparing Countrywide with its peer), nearly all of the failed or failing regional banks of significant size (As I see it, these 32 banks and thrifts are in deep doo-doo!), MBIA (A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton) and Ambac (Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap and Follow up to the Ambac Analysis), among others - well in advance.

More Goldman Sach's Research:

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Free research and opinion

• Reggie Middleton on Goldman Sachs' fourth quarter, 2008 results
• Goldman and Morgan losses in the news, about 11 months late
• Blog vs. Broker, whom do you trust!
• Monkey business on Goldman Superheroes
• Reggie Middleton asks, "Do you guys know who you're messin' with?"
• Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis
• Reggie Middleton on Goldman Sachs Q3 2008

§ As Reality hits, the Masters of the Universe are starting to look like regular bank employees

Premium Stuff!

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Historical context for the "Riskiest Bank on the Street" moniker.

Banks, Brokers, & Bullsh1+ part 1

Wednesday, 19 December 2007 | Reggie Middleton

A thorough forensic analysis of Goldman Sachs, Bear Stearns, Citigroup, Morgan Stanley, and Lehman Brothers has uncovered... Last week, Morgan Stanley called Citibank the “short play of...

The Riskiest Bank on the Street
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)

A closer look at the exposure of the other brokers
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)

I am really proud of our president, but I am truly suspect, no... disappointed in some of his economic team appointments and the holes in their recent ideas. This may really come back to bite him in the ass. Granted, this may be a bit unfair since I may have considerably more financial knowledge and acumen than even the most accomplished politicians, but a mistake is a mistake.

Heavily excerpted from TPMMuckraker:

Harvard Derivatives Whiz Fired For Emailing Larry Summers About "Frightening" Trades?

...

A former quantitative analyst at Harvard Management Company, the university's once-vaunted endowment manager, tells the Harvard Crimson she was fired for voicing concern to then-university president Larry Summers' chief of staff about the money manager's risky use of derivatives the traders didn't understand.

The episode dates back to 2002, when analyst Iris Mack, whose website identifies her as the second African American woman to earn a Harvard PhD. in applied math (and someone who likes primary colors) joined the much-venerated Harvard Management Company, which invests the university's then $18 billion endowment, to find what she termed a "frightening" state of affairs.

"The group I was working for had no background whatsoever to be working on [derivatives]," Mack says, adding that, to her knowledge, several of her colleagues were not licensed securities traders. "Sometimes the ways they handled even basic Black-Scholes models [widely used to price stock options] were puzzling."

So Mack took inventory of the abuses -- high employee turnover, lax risk management practices and a "low level of productivity in the workplace" were among others, and detailed them in an email to Marne Levine, Summers' chief of staff and a Treasury staffer on the Obama Transition Team. (Summers was the only person to whom Meyers reported, and according to a recent Forbes story he personally ordered the university's biggest derivatives trade, a purchase of interest rate swaps that cost the university billions this year.)

A month after sending her email, Mack was fired after a meeting in which the endowment fund's then-chief furnished her the emails and castigated her for making "baseless accusations." She later sued for wrongful termination and settled out-of-court with the university. But she claims the practices "shocked" her, and -- the punchline is -- she had joined the company from Enron.

Which is also to say, lest you dismiss Mack as an opportunistic snitch capitalizing on Summers fateful opposition to regulating the derivatives that wreaked havoc on the financial system, she had a pretty valid reason to believe in the importance of whistleblowing.

"I'm not trying to pretend I'm omniscient or anything, but a lot of people who were quantitative traders, in the back of our minds, we knew a lot of these models were just that: guestimates," Mack says. "I have mixed feelings, on the one hand, I wasn't crazy, I knew what I was talking about. But maybe if more and more people had spoken up, the economy wouldn't be the way it is now."

...

If Mack's allegations are true Harvard certainly paid the price for its recklessness: Summers' swaps sowed the seeds for a financial disaster at HMC:

It doesn't feel good to be borrowing at 6% while holding assets with negative returns. Harvard has oversize positions in emerging market stocks and private equity partnerships, both disaster areas in the past eight months. The one category that has done well since last June is conventional Treasury bonds, and Harvard appears to have owned little of these. As of its last public disclosure on this score, it had a modest 16% allocation to fixed income, consisting of 7% in inflation-indexed bonds, 4% in corporates and the rest in high-yield and foreign debt.

...

But risk brings pain in a market crash. Although the full extent of the damage won't be known until Harvard releases the endowment numbers for June 30, 2009, the university is already working on the assumption that the portfolio will be down 30%, or $11 billion.

Mack's boss at HMC, Jack Meyer, parted ways with the university in 2005. His bets were still paying off but his relationship with Summers had reportedly cooled -- among other things, over alumni outcry led by the university's Class of 1969 over the hedge fund-sized bonuses being awarded to employees of a supposed nonprofit. But if there's anything we've learned from the past year, gratuitous compensation and gratuitous risk go hand-in-hand.

"The events of the last year show that the whole procedure of rewarding people so handsomely based on increases on paper value of the endowment was deeply flawed," says a spokesman for the [Class of 1969], which recently sent a letter to the Harvard president suggesting HMC staffers return $21 million of their latest bonuses. "Even now we don't really know how well it has done in the last ten years."

The title says it all, but at the end of the day (or more accurately, at the end of the week and a half -on average), they are still just bear market rallies).

We have identified 5 bear market rallies based on 3-day , 5 -day, 7 day and 10 day cumulative return. On an average bear market rallies last for 9 days with an average gain of 16% from trough-to-peak.This most recent bear rally run has been the most violent, and the largest single move in the history of the markets. That means that it is a possibility the bear market is over - not! I have run multiple scenario analyses, though, just to be sure.

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Excerpted from From the NY Daily News:

Giants claim defunct firm Lehman Brothers owes team $300M

Big Blue claims the bankrupt investment behemoth owes the team $301.8 million from a complex financing deal for its new stadium in the Meadowlands.

The battle centers on a high-risk financial contract - the kind that has contributed to America's economic meltdown - between football's reigning champs and Wall Street's leading chumps.

It surfaced in a little-noticed, 238-page claim Giants co-owner John Mara filed in federal Bankruptcy Court on Oct. 17. It contends the team was guaranteed full payment because Lehman defaulted on its obligations.

The team filed a second claim to collect another $401,500 from Lehman to cover half of its $803,000-a-year bill for leasing an on-the-sidelines luxury suite with a bar and space for 24 guests, bankruptcy filings show. A stadium spokeswoman said the luxury suite issue had been "resolved." She refused to provide dThe Giants could also hire 38 wide receivers at Plaxico Burress' $7.85 million salary for Manning to throw the ball to.etails...

... "It would be quite unhealthy to hold your breath waiting for the Giants to get paid," said Reggie Middleton, who runs the Boom Bust Blog and was one of the earliest investors to warn of Lehman's impending demise. "They can expect to recover less than 9 cents on the dollar - a lot less - and they'll probably get zilch."

The Giants have a long wait before they can collect. "It could be as long as three or four years," said Lynn LoPucki, a law professor at both Harvard and UCLA and an expert on corporate bankruptcies. "Widows and orphans might qualify for a hardship claim and get paid earlier, but the New York Giants are an unsecured creditor - and they won't be on anybody's list to get paid ahead of schedule."

The flashpoint is the 82,500-seat, open-air new Meadowlands Stadium the Giants and Jets have been jointly building since 2007 on a 40-acre site across the Hudson.Complete with four restaurants, a Hall of Fame, 213 luxury suites, 2,000 video screens and a 300,000-square-foot outdoor plaza for tailgate parties, the stadium, expected to open in the spring of 2010, is budgeted at $1.6 billion.

To fund it, the National Football League loaned the teams $150 million apiece in 2007. The Giants and Jets each snared $650 million bank financing deals, with the Giants buying 40-year bonds from a seemingly healthy Lehman Brothers. Interest on those bonds, paid out until 2047, could be punishing, and the Giants wanted to reduce borrowing costs.

So they entered into a so-called interest rate swap with Lehman, "swapping" interest that could float much higher for fixed interest that would remain moderately priced, court filings indicate...

..."The agreement broke down the day Lehman declared bankruptcy" on Sept. 15, said Middleton, who analyzed the deal at the request of The News. The Giants were suddenly at risk of having to pay over time all the borrowing costs they had expected to save - an amount calculated at $301.8 million - because Lehman defaulted.

_______________________________________________

I have been crowing about investment bank and commercial bank insolvency for over a year now.

Why didn't Wall Street read my post on Lehman being a yellow lying lemon? See "Is Lehman really a lemming in disguise?"
and realize that this post was made on February 20th, when Goldman
Sachs had a recommended price of about $55 while this blog warned that
Lehman may be done for. This very similar to when I warned about the
potential demise of Bear Stearns in January, when the rest of the
Street had a "buy" at about $130 per share. See Is this the Breaking of the Bear?. We all know how both of these stories ended. Please click the graph to enlarge to print quality size.

image006.png

If I am not mistaken, didn't the major rating's agencies have an investment grade rating on Lehman leading up into its bankruptcy? What a damn shame.

I
spent the majority of my Wednesday spreading my bearish positions
further around the European banks (the balance was catering to my beautiful, yet demanding 2 year old daughter). Let me give you a glimpse into some of the
reasons why. First a glance at the home page of Bloomberg.com yields...

1. U.S. Stocks Plunge Most Since Market Crash of 1987 on
Recession Concerns- Sounds like a market crashing to me.

VIX Index of U.S. Options `Exploding' Amid Growing Concerns
About Economy- Hey doesn't this hypervolatility almost always precede a major market crash?

Bernanke Says Fed May Take New Role in Trying to Curb
Asset-Price Bubbles - Which
contradicts the story below. If you want to prick asset bubbles, you
can start by not letting them form, such as in allowing banks to
conceal the losses of assets on their books - in essence inflating
those asset values.

SEC Clears U.S. Banks to Postpone Writedowns on Value of
Some Securities-
And so it begins, the obfuscation of
true market values of assets held on bank's books. They can't fool me though.
Now, preferred stock is to be called debt. When is debt to be called preferred stock.
When are we going to be notified if or when the assets a bank is holding and
paid for with leverage have dropped in value by 70%. Doesn't that make the bank
worth less. Maybe not, after all stock is really debt, right?

S&P May Downgrade $280.1 Billion of Alt-A Mortgage Debt
Amid Delinquencies - But it doesn't really matter because
if you read the article above, banks don't have to write it down now. You know,
if I run into the middle of the highway, as long as I close my eyes so I can't
see the cars I'll be just fine.

Bush Says U.S. Taxpayers Will Get Back `Most' of Money Under
Bank Rescue- Of
course they will. Bush and his cronies have ever been the bastion of
credibility (Reggie Middleton says, "Don't believe Paulson": S&L 2.0 - bank failure redux, Is Paulson to be trusted, or is this Bush Administration Shock and Awe, 2.0? and Reggie Middleton asks, "Do you guys know who you're messin' with?"). Just look at bullet point one above: all of those levered equity
securities bought at the top of the stock bull run from 2003 to 2007 will
generate tons of return for tax payer as they overpay to buy them up.

What does all this have to do with my buying of the European banks bear positions? Well, most are still much, much too optimistic about the financial sectors prospects here. The Monday rally was an opportunity to go shopping, and shopping I did, for price and value diverged even farther. While I won't divulge what I bought, I will share a little anecdotal research (more empirical research on this may be available to professional level subscribers next week). Before we go on, if you haven't read Interesting Lehman email, it is must reading to fully grasp the weight of the rest of this article.

I recieved an email from a user which actually
struck a chord with me, since I did similar digging. I'm putting this
out here for discussion purposes only, and welcome all comments:

From
the research I have done I have found that most of the brokers
additional coverage on their customers cash accounts (the amount in the
excess of $100,000 covered by SIPC) is written with LLoyds. This is
the case with my account. Seeing that LLoyd's hit a new 52 week low
today when the market is up 500 points is not comforting to me - ticker
LYG (error on the part of the emailer, but his core point remains valid - see comments below). If things hit the fan (which anything goes in this environment),
do you feel LLoyd's could fail in their obligations to make good on
this insurance should we see more brokers fail? I am wondering if
Lehman was insured by LLoyd's to cover the $100k excess in their cash
accounts? This worries me and I'd like to know your thoughts on this
and who you feel the safest online broker is? And whether you think
LLoyd's is too big to fail? Is it a false since of comfort to feel
that we are covered beyond the $100k by SIPC?

Here is a short email exchange on the recent Lehman auction and announced CDS settlement. It is timely considering my admonitions in the Asset Securitization Crisis series and the Great Global Macro Experiment (must read). The explanation was broken down with numbers for those who use the left side of their brains:

By the way, what is your thought on the Lehman CDS settlement situation? I smell something funny there.

The financial media has crowed in adulation that "only $6B was paid out on ~$400B of nominal derivatives". But wait a minute. Didn't the auction yield a $.91 to face value settlement? Doesn't that mean there will be, in aggregate, about $36B of write-downs? Yes, $6B may have changed hands, but that is on a reduced nominal value, which HAS to cost someone.

If so, where will those losses land, and when?

I don't know enough about this process to answer those questions. But it certainly has occurred to me that all the orderly derivatives settlement process gains is that massive losses will be bled out over a long period of time, rather than all derivatives imploding at once. So we get banks and other financials under-performing for more years, instead of all going to zero right now.

The reply:

The investors footed the bill for much of the reduced nominal value, and the creditors and clients of the bank. Some prime broker clients will get pennies back on the dollar for thier accounts and have been forced to side pocket those assets, thus freeze their own clients money (much of which will not be returned at all).

As for the CDS payout, they were referring to a netting process, where bank A sold protection for Lehman to bank C, but bought similar 80% protection from bank B. Netted out, only 20% of net exposure had to be paid, THEORETICALLY.

Here's the real world:
The problem with the netting argument is that everyone is assuming bank B has the 80% to cough up, which they don't because they bought 80% protection from insolvent monoline MBIA to hedge them against bank A, but insolvent mononline MBIA reinsured with insolvent monoline Ambac, who sold protection to banks A, B, C, and D at 120x leverage and can't pay all of them at once.

Hence, bank C is f1cked, because bank A is f2cked by bank B, who got f3cked by MBIA who is currently getting f4cked by Ambac who can't pay everybody (or maybe even anybody, now), hence can generally be considered to be f5cking everybody involved.

Even common sense tends to evade these smart people. This is what happens when you are allowed to write OTC insurance without reserves, an exchange and regulations!

I expect this whole house of cards to collapse any time now. The problem is the revolution will not be televised.

You see, I don't use swaps, the primary reason being that when my gains are the juiciest, the likelihood of getting paid are the slimmest. Banks are rallying hard, again. I am slowly deploying my ample store of dry powder... Again, price and value have diverged significantly. Before we go on, make sure you have read:

• 
  
  CDS stands for Credit Default Suckers...
• 
  
  Lehman banrkuptcy + large, fragile unregulated CDS market = Kaboom!
• 
  
  The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath!
• Counterparty risk analyses - counter-party failure will open up another Pandora's box

Now, keeping the email exchance above in mind, notice what this astute gentlemen had to say (I have not verified the dates, but they seem right):

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http://blownmortgage.com/2008/10/14/derivatives-the-great-unwind/

Distracted by worldwide stock market
crashes, attention shifted away from Lehman’s derivatives’ payouts
scheduled for October 21. Recovery value has been set at 8.625 cents
per $1.00, which means that sellers of credit protection must pay
91.375 cents to the buyers (according to Creditex, the company that holds auctions).

More than 350 banks and investors signed up to settle credit-default
swaps tied to Lehman. The list of participants in the auction includes
Newport Beach, California-based Pacific Investment Management Co.
PIMCO, manager of the world’s largest bond fund, Chicago-based hedge
fund manager Citadel Investment Group
LLC and AIG, the New York-based insurer taken over by the government,
according to the International Swaps and Derivatives Association in New
York.

According to JPMorgan, the largest foreign bank holders of Lehman’s
derivatives are Deutsche Bank, Barclays, Societe Generale, UBS, Credit
Suisse and Credit Agricole. Overall, as of June 30, 2008, the top ten
US banks in terms of derivatives exposure were: JPMorgan Chase, Bank of America,
Citibank, Wachovia, HSBC USA, Wells Fargo, Bank of New York, State
Street Bank, SunTrust Bank, and PNC Bank, according to the Comptroller
of the Currency Administrator of National Banks’ Quarterly Report on Bank Trading and Derivatives Activities for the second quarter of 2008....

... Washington Mutual could be another story. It’s Credit Event Auction
will settle, meaning prices will be determined, on October 23. Just
last week there were credit events at the largest three Iceland banks,
all of which have large quantities of derivatives outstanding. These
are all financial institutions; industrials haven’t started yet.