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Banks, Brokers, & Bullsh1+ part 2 |
| Written by Reggie Middleton | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Wednesday, 19 December 2007 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Counterparty risk – why isn’t this in the media? Don’t these guys read my blog:-)All futures contracts offer extreme leverage over the physical commodity for which they represent a forward price. I will make a representative sampling of Morgan Stanley’s asset holdings to illustrate a point:
Now, Morgan Stanley has a large and lucrative prime brokerage business. This is the business where the banks provide infrastructure and research for hedge funds (wouldn’t it be funny if I got this research from Citibank or Morgan Stanley?) and loan them money on margin. They regularly give up to 20:1 margin to their good customers, with many customers receiving much more. They also enter into OTC arrangements with these clients, basically accepting credit risk (and market risk, hedged or unhedged) with the funds as a counterparty. These funds are not banks, and do not carry statutory capital requirements or minimum credit ratings. They are just pools of private capital. Hey, you know I’m cool with that. The issue is, how do you quantify the amount of credit risk assumed? Every bank does it differently. It is not standardized, and it possibly not even done very well. Nominally, as reported by MS, this counterparty exposure is 112% of capital. That is a lot. But wait!!!! Let’s look at the anatomy of a relationship. Let’s assume the hedge fund x is offered average leverage of 20:1 by MS Prime Brokerage services. MS is now selling that leverage and accepting the credit risk of an unrated, unregulated buyer. {For the record, I am totally against rating and regulating hedge funds. If you read my blog, you know how I feel about the big rating agencies, and regulation will just drive capital offshore - for good - while making no improvement here in the states! The solution is tighter risk management in the banks and brokerages – this is a private affair!} MS is doing this with 34x leverage itself. The buyer then buys invests in a portfolio like the one listed above in the futures and OTC markets, etc. at an average of 500:1 leverage. The hedge fund is effectively utilizing it equity leveraged (500*20=10,000) 10,000x on the physical and financial underlyings to speculate (and/or hedge – yeah, right). If things go bad, ex. Subprime debt or quantitative trading model blow ups, small moves can result in 10,000x losses to the equity, and multiply the 10,000x times the equity of MS’s equity capital multiplier, and you can have a doozy of a spell. I know, it sounds quite apocalyptic and these are just round unhedged, anecdotal numbers, but I am sure at least somebody gets my point. Admittedely, this does NOT take into consideration hedging, nor does it take into consideration applied portfolio theory, diversification, correlation management, etc. and yada, yada, yada. What it does take into consideration is reality rarely quoted. What I am trying to accomplish here is an illustration of how dangerous excessive leverage can be.
Now, all we need to do is multiply this exposure by about 1,500 or so hedge funds/private clients and apply hedges that were implemented as skillfully as those in the subprime mortgage markets, and voila! Instant Morgan Stanley counterparty exposure. Now, back to the banks…So, now that we know what these levels 1 through 4 are, how leverage can help or hurt us equity investors, and the mystery of who loans to who and how risky it can be - how does this apply to the big banks? Well, here is a rundown of who has what and where.
Now, looking at the raw numbers can be misleading. As you may know, most financial institutions are highly leveraged. They make their money by deploying capital. The caveat is, not all of the capital deployed is really theirs. They borrow most of it. Equity capital is what I will define, for the sake of this blog, as capital that actually belongs to the institution (and thus shareholders). All other capital will be considered leverage, in some form of fashion. This is an oversimplification, but at the end of the day, this is what it boils down to.
I think Merrill has been much more forthcoming (not necessarily on purpose) than most of their competitors. The street will report more asset write downs, & they're LEVERED UP! Here is a formula for a good short candidate: Asset write downs plus high leverage = Equity investors,”look out BELOW!” Why are O'Neil and Prince unemployed, yet the other CEO's still working? So, as you can see in chart above, Morgan Stanley is: · The most leveraged on the street at about 34x equity deployed · Has the most model risk of all of its peers here · Has 2 and ½ more bullsh1t level 3 assets than the company they had the nerve to call the short of the year (don’t get me wrong, I’m short Citibank as well, but still…), and more than any other bank on the street · Plenty of counterparty exposure, although they don’t lead the pack here · And lead the pack reported (that’s the key word here) proportionate asset write downs to equity (I don’t know how long that will remain true though, I see many more impairments ahead).
A breakdown of MS’s assets, by class.
A close look at MS’s counter party credit ratings. Read the 104 basis points Halloween story in this blog for more on my take on ratings agencies. It will make you laugh.
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Comments (11)
  written by rajendra, December 20, 2007
Reggie excellent postings on bankers, brokers, bullsh1...only one suggested the caption heads in the tables highlighted in blue are almost not legible. Could you do someting to fix this please. Regards
 written by Reggie Middleton, December 20, 2007
I am still working out bugs in the software, formatting being one of them. I need to install new editing code. This blog software was actually hacked together from various components, so it will be a couple of weeks before everything is working as planned. You know how software is.
written by Reggie Middleton, December 20, 2007
1.9 billion, or so. I still do not see where all of the optimism is coming from in terms of the banks and there real asset derivatives. Until the housing mess subsides (years), the derivatives connected to them will continue to get devalued. The only way to avoid it is to sell the depreciating asset. If it can't be sold, then write downs will continue until the macro environment changes.
This is true for mortgage banks, I banks, commercial banks, homebuilders, and commercial lenders/developers.
written by Me, December 21, 2007
Knowing you are stuck with the figures reported, your conclusions are conservative. Whether the unregulated investments are carried onto the balance sheets now or later the banks are insolvent. Fast forwarding, the situation leaves areas of opportunity for infiltrating and taking control of the banking system on a worldwide basis.
written by Reggie Middleton, December 22, 2007
I truly believe that the UShttp://www.rgemonitor.com/blog/setser/233759 and Europe are full of effectively insovent banks. The ECB finally jumped on board the liquidity bandwagon, and in a big way - injecting more cash into the system than they have ever done before - in one auction. Asia is coming down the pike as well, delayed by the manufacturing (vs. service) nature of thier highly dependent economies.
written by Me, December 26, 2007 this is a private affair! I suppose if full disclosure is attached to leveraged vehicles along with probabilities' plug-ins including projections allowing for no-growth phases then buyers would have awareness and sellers no fear of litigation. If this was the case and your computational physicist couldn't identify a Ponzi scheme then you deserve to go broke.
written by Reggie Middleton, December 26, 2007
I agree. Maybe investors should stop relying on just 3 ratings agencies whose rating opinion is paid for by the guys they are rating. Use the smaller, independent (and not so conflicted) analysts more often and simply just don't buy anything you don't fully understand.
written by Reggie Middleton, December 28, 2007
About those I banks and counterparty credit risks... From bloomberg.com:
Home Sales Sour When home sales soared this decade, bond insurers increased their guarantees of securities created from mortgages, including subprime loans to people with poor credit. They guaranteed almost $100 billion of CDOs backed by subprime-mortgage securities as of June 30, according to an Aug. 2 report by Fitch. Most of those guarantees are in the form of derivative contracts. Unlike insurance, those contracts are required to be valued at market rates at the end of each quarter. CIBC, Canada's fifth-biggest bank said ACA insures about $3.5 billion of the bank's U.S. subprime investments. Merrill Lynch & Co. may have used contracts with ACA Capital to pass off the market risk of $5 billion in CDOs, Roger Freeman, an analyst covering the brokerage industry for Lehman Brothers Holdings Inc., wrote in a Nov. 5 report. If ACA Capital defaults on its swap contracts, Merrill Lynch could recognize unrealized losses on those securities of about $3 billion, Freeman wrote."
written by Reggie Middleton, December 28, 2007
In WSJ.com: It isn't just consumers who are having a harder time getting credit from lenders. It's hedge funds, too. Investment banks are cutting back on loans to hedge funds, eliminating some clients and raising borrowing fees for others. The lenders are slimming their balance sheets after heavy losses in the debt markets in recent months. And, after taking multibillion-dollar write-downs, they also are becoming more cautious as the economy slows, according to people familiar with the situation. "Banks aren't in a position to be accommodating at the moment," said Michael Hintze, chief executive of CQS, a London-based hedge fund with $9 billion under management. If the change continues, it could put some pressure on the profits of the prime-brokerage units of the major banks, which make big money by lending to hedge funds, as well as helping the funds manage their cash and short stocks by borrowing and selling shares as a bet on falling prices. The move also could put pressure on the returns of some hedge funds, which of | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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