From Fitch's latest report :

As the U.S. housing crisis continued to deepen in 2007, Fitch’s global
structured finance rating actions took a decidedly negative turn, driven
overwhelmingly by the unprecedented credit deterioration in the U.S.
subprime mortgage sector. By year’s end, U.S. subprime-related
downgrades affected 3,529 tranches, or 77% of the year’s 4,570 global
structured finance downgrades. Total downgrades readily topped upgrades
of 1,790, the first year in recent history to see such a trend in structured
finance. However, the nonmortgage ABS and CMBS sectors reported
more upgrades than downgrades in 2007.

The subprime mortgage sector downturn also pushed up the global
structured finance default rate in 2007 to 1.19% from 0.37% in 2006. The
average annual global structured finance default rate over the 17-year
period ending in 2007 subsequently moved up to 0.77% from 0.68% in
2006...

In reviewing 2007 global structured finance rating
activity, it is important to note that credit quality
continued to deteriorate in the subprime mortgage
and CDO sectors in early 2008, resulting in
additional and significant negative rating migration.

Highlights
• Fitch’s global structured finance rating activity
turned net negative in 2007, with downgrades at
least 2.5 times more frequent than upgrades and
a record 14% of structured finance tranches
experiencing negative rating actions over the
course of the year, compared with 6%
experiencing positive rating actions. This
produced an upgrade-to-downgrade ratio of 0.39
to one in 2007, a stark contrast to the 4.54 to one
ratio reported in 2006.
• Despite weak performance in the U.S. subprime
mortgage securitization and CDO sectors, 80%
of global structured finance ratings remained the
same in 2007. However, this is down from an
85% stability rate in 2006.

From WSJ.com:

Some 10 months after the mortgage hurricane made landfall, Merrill Lynch & Co. is still trying to dig out.

On Thursday Merrill will report $6 billion to $8 billion in new write-downs, according to a person familiar with the matter. The latest would bring its total since October to more than $30 billion and mean that Merrill reports a third straight quarterly net loss, the longest losing streak in its 94-year history.

New chief executive John Thain has said that, having recently raised $12.8 billion in fresh capital, Merrill won't need to seek more in the foreseeable future. Mr. Thain has increased the importance of weekly risk-management meetings by requiring the heads of trading businesses to attend and by having the top risk managers report directly to him. Since taking over in December, he also has reduced executives' incentive to swing for the fences by tying more of their pay to the firm's overall results and less to how businesses do individually.

Yet as of year end, Merrill still appeared to be taking large risks. Its "leverage ratio" -- how many times assets exceed equity -- stood at 31.9 to 1, higher than most other Wall Street firms. Heavy borrowing like this magnifies both profits and losses.

This does not solve the problem, it just incentivizes star employees to jump ship when they overperform yet have their bonuses dragged down by those that don't. What you need to do is give them what they want. If everybody wants mini-fiefdoms, then they get it - all of it. Producers, bankers and traders should be individually responsible for risk AND reward. Currently, they get paid only for the rewards they produce, and the shareholder gets stuck holding the bag of risk - with most of the reward stripped out in the form of overly generous compensation.

In my entrepenerial financial pursuits, not only do I not have a regular and reliable salary, but I am fully responsible for risk and reward. Although I still take significant risks for a living, they are in no way (and never will be) outsized in relation to the commensurate reward. As a matter of fact, I won't even take a risk if the reward doesn't outstrip the risk. The risks that I take may seem large to the untrained eye, but they are actually small when taking the whole pie into consideration. The extreme volalitility that I faced head on with large directional bets are an example of such. I was short certain sectors of the market, and as volatility spiked, trash companies rallied hard and short covering ramped up I sold shorts and/or bought puts into these rallies. This resulted in my account showing much more volatility than the broad market averages and mutual or hedge fund indices, but at the end of the day the resultant profit easily outstrips all indices and averages by several multiples - even according to all of applicable risk adjusted measures. A quick perusal of my blog should confirm this in an indirect way.

I am able to discpline myself in the gorging of volatility and market risk because I am responsible for my own losses and have no one to lay them off on. If the bankers, traders, and sales persons of Wall Street had the same responsibilities, I am sure the genius in them will be able to produce similar results. If you read the entire article linked above, it appears to be spotted with many "managers" who were not compensated with risk adjusted return, just with return. Thus they pushed for imprudent risks. This is not the way to do it. Be entrepenurial.

Hey, Merrill, this individual investor is available for consulting if you need him.

This was referred to me by a reader whose email I misplaced, so I cannot give him a hat tip, but thank you anyway. Here is an excerpt from Institutional Risk Analytics :

Here's our question: Why did the Fed of New York facilitate the rape of BSC by JPMorgan Chase (NYSE:JPM)?

The
announcement by the Fed of a new lending facility for broker-dealers to
borrow from the discount window, made just hours after BSC's board of
directors apparently was forced by the Fed to sell for $2 per share to
JPM, strikes us as clear evidence of an anti-BSC bias by the US central
bank. Why not just lend directly to BSC under the new Fed loan
facility?

One prominent New York lawyer who is very well acquainted with the Federal Reserve Act tells The IRA
that the Fed of New York did two things last week: 1) approved a loan
to JPM, which was then passed through to BSC; and 2), created a new
facility to lend directly to broker dealers under Section 13 of the FRA.

"There
is nothing new here," adds the lawyer, who notes that the Federal
Reserve Banks made loans to individuals in the 1930s under the
emergency provisions of Section 13 of the FRA and could have easily
lent directly to BSC without involving JPM at all.

Thus
again the question to Fed of New York President Tim Geithner: Why was
JPM involved in this transaction? Why not simply extend liquidity
support to BSC as you now offer to every other primary dealer? As and
when BSC shareholders litigate over this mess, Geithner et al may be
forced to answer those questions in public.

To
us, even at $10 per share, the JPM buyout stinks to high heaven because
of the conflicted role played by the Fed of New York. Does anyone
believe that the Fed would force Lehman Brothers (NYSE:LEH) or Goldman
Sachs (NYSE:GS) into such a fire sale? Indeed, it looks to us like the
Fed of New York and BSC both got rolled by JPM CEO Jamie Dimon and his
merry banksters. But the JPM crowd won't be laughing much longer.

The
same forces that pushed BSC into insolvency are working on JPM and the
other money centers as you read these lines, but JPM first and
foremost. Just look at the range of valuations included in JPM's
disclosure to Canadian officials regarding price estimates for illiquid
structured assets and you can see why JPM's Dimon has been so upbeat in
recent months.

From the WSJ:

Stocks were unable to
hold onto Tuesday’s 400-plus point rally in the Dow industrials and
attendant rallies in other indexes, and steadily marched lower through
the afternoon, until news of a lawsuit filed by Merrill Lynch against a
unit of bond insurer Security Capital Assurance, alleging the company
is trying to avoid obligations of up to $3.1 billion under seven credit default swaps.
Merrill’s own CDS widened on the news, moving to 250 basis points from
210 basis points, according to Phoenix Partners Group, and the stock
market dove, with the Dow giving back a good lot of the previous day’s
massive rally.

I stated several
times in the comments that the CDS market may very well lead us into
the next serious leg down. Many of the guys who wrote these either
don't have the cash to pay up or are wrapped up in hedges using CDS
which will easily get @#$@ed up once one leg of the hedge falls.

My blog has been quite popular as of late,
most likely because it may appear to some that I have a crystal ball.
My last 5 or so warnings have resulted in 50 point or so price drops in
the shares of the companies in questions. Let me be both modest and
honest. I am not that smart and do not have a crystal ball. There is a
simple premise behind all of this that allows me to understand what is
going on, but this premise does not get any press play and is not
harped on by the analyst community. Many major players in our financial system are simply insolvent.
Plain and simple. The liquidity issues that you see are simply a result
of that insolvency, not a cause. When you lever up on assets at the top
of a bubble and that bubble pops, you become insolvent, delevered or
not. If forced to delever, the balance sheet insolvency now becomes an
income statement insolvency as the cash outflow outstrips the cash
inflows, but it all stems from the original balance sheet insolvency -
not the other way around.

Borrowing more money, no matter what the
terms, will not aide you in your dilemma. That is, of course, unless
you can borrow large amounts of that money quickly on non-recourse
terms. But that is not really borrowing money, it is someone giving you
money with the option to pay it back.
It is the equivalent of a straight bailout, isn't it? That is what just
happened last weekend, which leads me to the next paragraph...

I have been alleging that many investment banks, monoline insurers, home builders and commercial banks are effectively insolvent. Nouriel Roubinin wrote an accurate piece on the topic.
Between that and the the five or six major analytical pieces that I put
together, I believe a pattern emerges (please take note of the dates
the pieces were written and the share prices at the time of the post).
I believe the pattern is indisputable. You could have made a fortune on
the short side of these analyses, and you could have lost a fortune on
the long side, just ask the employess and shareholders of Bear Stearns,
Ambac, MBIA, Lennar, etc. My condolences go out to the rank and file
employees of all of these companies whose savings have been lost in the
share price devalution. Hopefully, there is a lesson to be learned
here:

• 
  Are the Mortgage Insurers in Serious Trouble? 9/3/2007
  

• A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton -11/13/2007

• 
  Tie-in to the Halloween Story11/21/2007
  
• 
  Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion in Equity 11/29/2007
• Follow up to the Ambac Analysis 12/4/2007

More on Insurers and Insurance

• 
  The Commercial Real Estate Crash Cometh, and I know who is leading the way!

More on Commercial Real Estate

• 
  Lennar Insolvent: Enron redux???

More on Residential Real Estate

• 
  Banks, Brokers, & Bullsh1+ part 1
• Banks, Brokers, & Bullsh1+ part 2
• Money Panic
• Bear Fight
• The Breaking of the Bear
• The Riskiest Bank on the Street
• Here comes the CRE Bust (Quip on Lehman Brothers)
• Is Lehman a Lemming in Disguise (from a conributing individual investor)
• Liquidity vs Insolvency
• Bear Stearns Bear Market, Revisited

More on Investment Banks

As you can see, the path was not impossible to determine as
practically all of these companies shared the same catalyst to their
downfall - excessive leverage at the top of an asset and credit cycle
bubble. Now, the Fed is attempting to lend directly to institutions
that it has no jursidiction over. If I am not mistaken, the Fed's
balance sheet is only good for $400 billion dollars or so. There are a
lot of potential "runs on the non-bank" coming down the pike, enought
to drain the coffers. This is an ingenious, albeit very risky endeavor.
Moral hazard abounds. I know the Fed believes that they have nixed the
moral hazard argument in the butt by wiping out the Bear Stearns
shareholders, but this is an imperfect argument. The shareholders have
to approve this $2 buyout deal, and $2 is low enough to risk a battle
with the Fed and their agents. This is a major flaw in the plan that I
see as coming back to bite the markets. If this happens when the next
shoe drops, I can see the Fed getting overwhelmed.

As an investor and analytical pundit, I will be looking for the next
shoe to drop, which I believe I have found. I will keep you posted.

JP Morgan bought Bear Stearns for $230 something million, about 7%
of its closing price Friday, and about 2% of what it was trading for 2
weeks ago. On top of it, this was an all stock deal with the government
funding more tha 100% of it (the Fed will be financing $30 billion of
non-liquid BSC securities, the back stop that I said would happen).

To
put this into perspective (I'm a NYer, so I am quite familiar with the
landscape), the BSC headquarters is worth at LEAST $1 to $2 billion.
Between the clearing infrastructure, asset management, structured
product assets and real estate, there is at least a $1.5 billion
immediate gain here. How much that will be offset by litigation risk is
an unknown. The CEO got up on CNBC and clearly told the world that BSC
had no problems. Lawyers must be getting a boners in real time.

I
will admit to a big mistake that I made. I hedged my gains at $35
Friday to lock in the profts. Those calls are literally worthless now.
I shouldn't be complaining since my gains as of this post are averaging
over 800% on this trade, it was the largest position in my portfolio,
and that was after taking profits last week. Just thought I would be
honest and let everyone know that I am far from perfect, thus as I have
said so often, no one should be taking anything I say as investment
advice.

Now, as for Monday's trading.... I am not a trader, and
I believe in medium to long term investment horizons, but there is a
LOT of opportunity to be had here. Lehman is probably going to get a
drubbing. Morgan Stanley is being overlooked by the Street. Citibank
will get no love. I already covered on WaMu, with all of the
opportunities abound, I don't believe that I should be trying to dabble
below $10 when I have ridden shares down from last year in the $30's.

I
fear Goldman will be seeing a lot of devaluation. Don't forget the
companies that we have covered earlier in the blog. There financing is
damn near gone. GGP, the builders, etc.

The Fed is working hard
to help the country. That is undeniable. They have cut rates, extended
financing directly to non-banks, cut more rates - but, and as I
thought, the markets are ignoring these actions and driving financials
down and commodities up.

Lehmans asset make up will make it a
target in US trading. I will probably attempt to expand my position and
will be willing to pay premiums. My small position is quite profitable
already. I will attempt to expand the financials on my list in
aggregate, and MS (who is my 2nd largest position in the financials)
will be expanded as well.

One thing of note - The Fed's attempts to prop up the market should
help most banks, but the issue is that the bank's problems are that of
solvency and not liquidity. Liquidity problems have popped up, but they
are a consequence of the market being fearful of insolvency. The Fed
has created a limited backstop against general liquidity issues, but if
there is another run on the bank the Fed will not be able to afford to
stop it. Even if they could, they can't stop all of them by supplying
money. If there is a run on the bank, Lehman is next in line. I mention
this because if you really read my pieces - Banks, Brokers, & Bullsh1+ part 1
and Banks, Brokers, & Bullsh1+ part 2 you should walk away appreciating the risk between large private
investors and the I Banks. The I banks are starving for liquidity to
balm their solvency issues, so if they get money from the Fed you can
bet your booty that they will not be lending it back out (I was told that the banks were told by the Fed to allow their clients to borrow through them to the Fed window, but seeing is believing). They will
also be very jittery about collateral and credit risks, which means
more margin calls. The calls will be devastating. That means that if or
when banks start calling in collateral, the crash just may occur in the
hedge fund/private institutional investor arena before the actual I
bank arena. I that happens, the collateral will devalue futher as
deleveraging occurs, and it will put a liquidity strain on the I banks
again as they bang against the Fed's lending facility. I can't
guarantee this will happen, but it is a distinct possibility.

Stories from RGE Monitor and around the net related to Banks, Brokers, & Bullsh1+ part 2:

• Carlyle Capital Corp (CCC) defaults on about $16.6 billion of AAA agency debt as widening spreads led to huge losses and margin calls on position leveraged 32 times. Lenders seizing all of its assets--> Carlyle Group's only material financial exposure to CCC is through a $150 million unsecured subordinated revolving credit agreement with CCC.
• Sudden Debt, FT: Almost all structured finance transactions are based on unfunded margin debt--> Margin debt cannot be "restructured" with falling asset prices.
• Brunnermeier/Pedersen (Princeton/NYU), BIS: Under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals.
• Whalen (IRA), Joseph Mason: With prime brokers and hedge funds there is no such thing as a "true sale" or complete risk transfer because the hedge fund has little capital and the prime broker, as a result, ultimately bears all the risk. Same as securitized assets landing back on balance sheet without capital to account for them.
• InvestorsInsight: Hedge Funds are net sellers of credit protection in CDS market, like insurers. Seides: hedge funds sell 32% of all CDS ($14.5 trillion) with only about $2.5 trillion in net assets under management--> watch counterparty risk.
• S&P via FT Alphaville 75% of loans to junk-rated U.S. companies provided by HF/non-banks (about $400bn)--> worst asset class performance in Q4.
• Peloton hedge fund run by former Goldman Sachs partners is liquidating $1.8bn ABS fund that produced 87% gain in 2007. Potential $9bn asset fire sale.
  Strategy: go short subprime paper, go long prime rated paper--> as of Jan 2008 however spreads on both low and prime rated assets widened due to deleveraging (=reverse leveraged bets on good assets). Margin calls triggered decision to unwind.
• FT Alphaville: January 08 worst month for hedge funds since August 1998 LTCM episode--> average fund tracked by the HFRX index lost more than 2% in January, with event-driven funds, which include activists, the worst hit with a 3.39% loss. Equity long-short funds with net long exposure down too.

The amount of equity devaluation has literally doubled BSC's leverage and potentially halved the market's confidence in this company. At this point, I would feel comfortable issuing a going concern warning.

All banks use excessive leverage to monetize the perception that they can make money for their clients. BSC has lost that perception, thus is at risk of painful deleveraging, by force. They will also have a hard time incentivizing strong talent with such a weak share price and no cash to spare. They aready have the highest bar to cross in regards to compensation as percent of tangible equity and revenues.

I would like to waltz through today's news, but before I do... For those of you who haven't read my pieces on the I banks and brokers, I urge you to peruse (in the following order):

1. Banks, Brokers, & Bullsh1+ part 1
2. Banks, Brokers, & Bullsh1+ part 2
3. The Riskiest Bank on the Street
4. Is This the Breaking of the Bear?

I know it is a lot of reading, but I feel it is well worth the time if you have any financial ties to this indutry, and the subject companies explored, in particular. The forced liquidation of asset backed securities and mortgages this weak definitely makes these researched opinion pieces appear awfully prescient. I, unfortunately, cannot take credit for being a genious since the writing was clearly on the wall. As for what is happening to the companies in question, well, readers of my blog not only saw this coming but know that the worst is yet to come. The financials are not even halfway through their downcycle, and some of the big name brands are at risk of insolvency. Let's turn to today's WSJ.com:

Hedge Funds Squeezed As Lenders Get Tougher

The financial turmoil is taking on a new dimension: Banks that lent money to hedge funds and other big risk-takers are asking for some of it back.

Loans from banks and brokerages had allowed hedge funds, which manage some $1.9 trillion in clients' money, to amass many times that amount in investments. But as the value of mortgage-backed bonds and other investments has dropped in recent weeks, the lenders are demanding that borrowers put up more cash or assets. (Banks, Brokers, & Bullsh1+ part 2 - credit risk?)

This is producing a negative cycle that has policy makers deeply worried. When investors rush to dump assets, prices fall and lenders feel compelled to make further demands, or "margin calls," which cause even more selling.