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.