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:
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 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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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
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.
I am going to introduce a paradigm shift in the content that I introduce to the blog. As reporters and institutional investors who have contacted me can attest, I have been very secretive and stand-offish in terms of what I do for a living. The reason is that I was in the process of launching a hedge fund, and my lawyers were quite explicit in telling me that I am in no way to promote the fund through the blog. You see, I think I'm pretty good at this investment stuff, and I needed access to more capital to fully exploit the next step in my investment thesis. So, what better route than to open a fund up to investors who can appreciate my investment style, and take advantage of that 20:1 leverage offered so freely. Well, one of the reasons I have had such a strong investment record is that I am able to smell bubbles. Unfortunately, I smelled this fund bubble coming but I thought I could sidestep it. I seem to have been wrong, but didn't realize it until after I spent an upper middle income family's salary on fund formation. With a raft of adverse legislation, tightening operating environment and increased regulation, this bubblicious industry just ain't what it used to be.
This bank is in big trouble. Notwithstanding their own credit issues, a slowing business cycle, and horrible macro conditions, they actually paid $100 billion for acquisitions in the last 5 quarters. This company wasn't even (IMO) worth $100 billion in the last 5 quarters. Talk about subprime borrowing!
Two of those acquisitions were the largest companies in their respective industries, along with the largest problems caused by the Asset Securitization crisis (or one could say caused by them). Merrill Lynch led Wall Street in asset value writedowns, and I don't think they were really all that aggressive in doing so. Countrywide is a gaping radioactive cesspool of liabilities and underwater assets (see the posts below from LAST YEAR). They actually have practically as much in REOs (dollar value) as performing mortgages. This makes them effectively a real estate company - against their will. The legal liabilities appear to be near limitless. What the hell was Ken Lewis thinking when he bought these two companies? Integrating a large acquisition is hard enough, doing 5, with 2 being the largest in their respective (very large) industries during the worst credit and real estate downturn since the Great Depression, as your own credit and earnings metrics deteriorate in the face of nearly $10 billion + worth of legal liabilities seems to be a form of corporate hari kari. Then again, what does a lowly blogger know about the intricacies of high finance and corporate machinations...
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So, Merrill, who up until recently was the world's largest brokerage firm and investment bank, gets bought by Bank of America on the cheap (or maybe not so cheap considering the quality of its assets). Lehman prepares for a bankruptcy filing by midnight tonight, as its counterparties scramble to cross net trades. For those who don't realize it, those $70 billion or so of assets that allegedly did not have a credible bid, will now be dumped onto the market in a bankruptcy sale. Pundits are crowing that the Fed's credit life-line to Lehman will allow for an orderly liquidiation. Not happening... Lehman couldn't dump these assets as a going concern, so what they hell makes anyone think that a bankrupt Lehman hanging by a government credit line thread (which may not even be available since it may no longer be a going concern) as creditors bark down its throat for payment will have even a comparable time getting anything above a penny a pound for these assets? Boys and girls, the sh1t apparently has hit the fan. I've been working on this for a couple of days, but I'm going to release it early and unfinished since current events have made it even more pertinent and timely. Please excuse gaps in thought and logic since it is an unfinished work.
There has been a lot writing lately about the coming
collapse of the shadow banking system in the US, hence the global shadow
banking system. In lieu of repeating the arguments which have been made so many
times on the web (and in my blog),I will simply link to two of them. First,
there's the ever so cheerful
Nouriel Roubini, and then this guy who I have never heard of but who appears
to mirror my thoughts, and to a lesser extent this FT blog. The issue with the FT blog is not its accuracy, for it is on point, it is just the extent (actually, the lack thereof) of its bearishness. The good professor harps on exposure to real assest, mortgages, etc. combined with asset liability mismatch being the catalyst of the weaker banking players fall. I argure that all of the shadow banking system's universal I bank players are at extreme risk of failing (this was written right before Merrill Lynch agreed to be bought and Lehman prepared their bankruptcy filings - so you see I was right, 3 or the nations 5 top banks went bust or bye-bye in less than 6 months - the other two are on standby). All of the US I banks have asset liability funding mismatches, they all of leveraged exposure to popped bubble assets (real property, mortgage derivatives, leveraged loans, leveraged private equity), and most importantly, they do not report the economic risk assumed in the generation of accounting earnings. This is my argument for the short of Goldman Sachs (see the sidebar for related reading). An accurate reporting of economic risk assumed in profit generation on risk adjusted assets would removed the incentive to play the off balance sheet SIV games that hide the bulk of the surprises for the banking industry. Nobody really knows how much risk was taken to generate the accounting rewards reported quarterly, and no one really knows the quality of the assets "allegedly" being reported on. I know one thing for sure. That quality level is not very high. Then again, we have the CDS dilemma, which I will get into in detail a little.
Is Lehman too big to fail?
Obviously not. It is failing, isn't it? The question of the day is, "Can it be allowed to fail? Lehman is very closely intertwined with US, UK and Eurozone banks through the CDS network. Either it, or one of the other 4 or 5 "quasi" bank failures coming down the pike will set this powder keg a kindle. Let's take a look-see at exactly what is making these banks go pop.
A comparison of the major US investment banks reveals they are cooking dinner with the same seasonings!
Why did Bear Stearns collapse just a few months ago? Contrary to popular belief, it wasn't liquidiy. Lehman has access to unlimited liquidity trhough tht government lending window. Bear Stearns, like Lehman, like Merrill Lynch, like Washington Mutual, like IndyMac Bank, like Fannie and Freddie Mac, like Goldman and Morgan Stanley, are insolvent - that is what's causing the malaise! A quick (historical - this was drafted in January) Bear Stearns drill down reveals the root cause. Notice the highlights in red representing the similarities among the various banks mentioned below. Keep in mind that the investment banks are basically giant hedge funds (in the guise of proprietary trading desks that include clients subscribers) who gamble their own capital along side that of their clients, with secondary fee-based revenue streams from activities such as M&A, securitization (used to be), and brokerage...
Level 2 and Level 3 Assets – Model Risk run amok!
risk, or the risk of the bank living in a spreadsheet in lieu of the
market, has already reared its head in the summer of ’07 with the blow
up of two of BSC’s hedge funds, which have left them in litigation with
their own customers. Basically, many of the assets of the fund were
levered highly, and valued based upon modeled cash flows from assets,
and not from the actual tradable value of the assets. This is fine,
until you need to liquidate by selling assets. As luck would have it,
they found no market they felt was acceptable and were forced to mark
value down significantly, approaching zero. It has also manifested
itself in the announcement that they will be
moving at least 7 billion dollars to the level three (the most
BullSh1+) category. Bear Stearns has recently announced another hedge
fund blow up, which doled out
significant losses to investors and is attempting liquidation. For my
laymen’s plain English take on level 1, 2, and 3 asset accounting, see the Banks, Brokers and Bullsh|+series (Banks, Brokers, & Bullsh1+ part 1 for model risk,).
Level 3 Assets at 231% of Total Equity; Amongst the Highest on Wall Street
the top investment banks, Bear Stearns has one of the highest exposures
to the riskier class of assets. The company’s exposure to Level 3
assets further increased by $7 billion to $27 billlion as of 30
November 2007, representing almost 229% of its equity, as compared to
70% for Merrill Lynch for the same period. Bear Stearns also has a
$43.6 billion of MBS & ABS inventories of which $15 billion is in
the CMBS portfolio. In addition, Bear Stearns is exposed to riskier
assets through its arrangements with Special Purpose Investment
Vehicles (SIVs) having assets totaling $41 billion, of which $37
billion comprises Mortgage Securitizations.
the assets which makeup the Level 2 and Level 3 assets such as
distressed debt, non performing mortgage related assets, MBS, Chapter
13 and credit card receivable which are likely to decline in value, our
default probability ranges from 2% to 20% in the base and worst case
scenarios. Moreover, considering the addition of $7 billion from level
2 to level 3 assets in 4Q 07, we have conservatively assumed a base
case default probability of 2% on the Level 2 assets.
For those that have been following my posts on the investment banks, these companies have been quite profitable for my proprietary account. To date:
- Banks, Brokers, & Bullsh1+ part 1
- Banks, Brokers, & Bullsh1+ part 2
- Jeffries Group observations
Bear Fight - A most bearish view on Bear Stearns in a bear market
- Is this the Breaking of the Bear?
- Bear Stearn's Bear Market - revisited
Is Lehman really a lemming in disguise?
- The Riskiest Bank on the Street
- Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street
July 9 (Bloomberg) -- Morgan Stanley, the second-biggest U.S. securities firm by market value, lost money on 16 trading days during the second quarter, twice as many as in the prior period, as the firm made wrong-way bets on energy and stocks.
The firm also earned $125 million or more on 10 trading days during the period, one day less than in the first quarter, according to a filing with the U.S. Securities and Exchange Commission today. Goldman Sachs Group Inc., the largest U.S. securities firm, said this week that it lost money on 20 days in the second quarter, up from 17 days in the first quarter.
... During the second quarter, Morgan Stanley reclassified to Level 3 from Level 2 about $7.2 billion of corporate and other debt, including commercial mortgage loans and commercial mortgage-backed securities, because of a decline in trading and available market prices. At the same time, about $5.8 billion was reclassified to Level 2 from Level 3 as trading resumed for certain corporate loans and loan commitments.
Goldman Sachs this week said Level 3 assets fell to 7 percent of the total from 8.1 percent in the first quarter.
Morgan Stanley's so-called Tier 1 ratio, which bank regulators monitor to gauge a lender's ability to withstand loan losses, was 12.4 percent in the second quarter. That compares with 10.8 percent at Goldman.
This is another one of those analyses that you won't be able to get
from your local brokerage house, along the same vein as my last GGP
post (GGP and the type of investigative analysis you will not get from your brokerage house
). It is the stuff only available from the blogoshpere minority, or
high end buy side groups (who really tend not to share much).
I'm a private investor and I pride myself on an analytical approach
to investing. I try very hard to look at things from a scientific
perspective of risk vs. reward. It is an indomitable tenet, one that I
attempt to instill within my three children, and one which has (at
least for the last 8 years or so) has provided me with an investment
return that is multiples of the broad market. Unfortunately (or maybe
fortunately, in regards to my investment record), it is one which is
not shared by most of the analyst community and those that follow them.
This brings me to the issue of Goldman Sachs. I have been bearish
on commercial, mortgage and investment banks for over a year now, and
have made a penny or two from this outlook. In doing this, I noticed
the illogical reverance that Goldman Sachs has recieved, both from the
analytical community and the media (bolstered by the name brand talking
heads). I never did buy into it. Goldman is a fine, well run, well
respected brokerage/banks, but it is still just that. They hire the
same people, who went to the same schools to get the same education, to
use the same strategies to trade/advise on the same products in the
same markets as all of the other banks. To assert that thier shit
doesn't stink breaks from my scientific method of analysis. So, let's
take a more analytical look at the media's Golden Boys...
I've been preaching about the risks the CDS market poses to the
financial system for some time now. Since the monolines faux business
model has been laid bare, we will start seeing some real action in this
arena. For those who don't want to take my anecdotal quips as gospel, I
actual go in depth through Reggie Middleton on the Asset Securitization
Crisis Series - The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath!. A worth read for those not familiar with the Credit Default Sucker's market.
Now, to the point of the post. UBS is in a lot of hot water these
days. Despite being eyeballs deep in rapidly disintegrating, highly
leveraged trash assets they are also often in hot water. Reference the
In depth: UBS - Apr-01
UBS to replace four directors - Jul-01
US tax purge looks beyond Swiss bank - Jul-01
Lex: Taming Swiss banks - Jul-01
UBS faces legal move on tax evaders - Jul-01
So, thus far we have had a massive real asset bubble fueled by easy credit, low interest rates and low inflation. We have had that bubble burst, inflicting severe damage in the commercial, investment, mortgage, and shadow bankin system as well as the real asset markets. Despite this, there is still a large overhang of inventory in real assets (dead weight), low demand, and cap rates are still near historic lows.
Well, I believe a spike in inflation, hence interest rates, will force cap rates upward and do what he investment public has failed to do thus far - and that is create a realistic pricing environment for both real assets and the credit derivatives that financed them. This will absolutely wreck margninal banks and the not so marginal banks who aren't doing that well - even in the zero interest rate environment promoted by the fed. So if the banks are sick now (see The Anatomy of a Sick Bank!) imagine how they will fare with the disease of inflation creeping up their backs. Since they power the real asset market, and the real asset market is still in the throes of bubble pricing, what happens next??? Think the S&L crisis! See the following excerpts from Reggie Middleton on the Assset Securitization Crisis for my take on how we will make the S&L Crisis look like an episode on Sesame Street. For those that remember or research, it was the rise in interest rates that pushed the S&L's over the bring - althought they probably had it coming anyway.
- Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
- Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
- Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
- The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
- Municipal bond market and the securitization crisis - part I
- Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
- Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
- More on the banking backdrop, we've never had so many loans!
- As I see it, these 32 banks and thrifts are in deep doo-doo!
- A little more on HELOCs, 2nd lien loans and rose colored glasses
- Capital, Leverage and Loss in the Banking System
I'm taking a closer look at GE, the industrial cum uber bank
bellweather of the Fortune 500. See the following draft overview, to be
followed up by a full forensic analysis. I apologiz, for I've had this
on my desk for a while and forgot to post it and was reminded about it
when a sell side analyst downgraded GE this morning.
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Electric share price has declined 22% in the last six months
The General Electric share price has taken
significant beating in the last six months and has fallen 22% on account of its
exposure to the financial services business and currently trades at US$29.05
per share. GE’s share price declined almost 13% on 11 April 2008 as it reported
a significantly lower than anticipated 1Q 08 results. The share price has
fallen by almost 21% since the announcement of its 1Q 08 results.