December 03, 2020

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  • I've had this research on MBIA sitting on my desktop for some time now, too busy to convert it into a post for the blog. The macro situation stemming from the real estate bust is unfolding just as I have surmised, albeit a bit quicker and more far reaching than I originally thought. It is scary, for nobody wants to see bad things happen to other people, and I don't want to get caught in a financial downturn regardless of how well prepared I try to make myself. On the other hand, these situations create significant opportunity for gain, primarily from those who refuse to acknowledge the fact that the wave is not only coming, but has reached us quite a while back. I have learned unequivocally what many probably new for some time now. What is that you ask? You really just can't trust government data. Now, I don't want to get into politics and conspiracy theories, but the data as of late has been so far removed from the obvious reality for many that it is almost signaling that the government doesn't even want you to heed the data and is giving you the requisite warning signals. Examples of which are employment data and inflation. Alas, and as usual, I digress, as such is the mind of insane idiot savant that my kids call Dad.

    Now, back to the title - What so special about the number 104? It is the number that will probably scare the pants off of anyone who is in equity investors, or potentially anyone who is a customer, of MBIA's insurance and guarantee products. It is the number that when reached, will leave the equity investor with shareholder certificates worth nothing. It is the number where MBIA's equity is wiped clean. Why are you being so damn cryptic Reggie, you ask? Because, I need for you to go through this history of how we came to this point before I explain in detail, so as to get a clear and comprehensive understanding of the situation. That is part of it; the other part is just because I feel like it. Now, let me give you a little cartoon of what the number is, then a background of how we got in this mess to begin with, then an analysis that shows how I got to this number. As usual, you can click on any graph to enlarge it.

    And then...

    Some time ago I came across this report on the MBIA and ABK by Pershing Square and found it absolutely intriguing. I posted it on this blog on September 3rd, when these companies were trading in the 60's and 70's roughly, and respectively (sometimes it actually pays to read this blog:-). I was actually impressed enough to take a small short position of my own without doing my own forensic analysis. This is something that I regret. Why? Because I am willing to assume significant risk once I convince myself of the strength of a position. Using third party research, I dabble at best - and rarely do I use third party research. So, I dabbled when I should have looked harder and took a significant position. After the fact, I looked further into the industry on an anecdotal basis, then all of a sudden, Bam! The proverbial feces hit the fan blades. The stocks fell so far, so fast, I was taken aback. So, I asked part of my analytical team to take a look at these guys, for I knew that a major problem the monolines, the banks, and the builders all had was a lack of understanding and respect for the rate of decline in value and default of instruments linked to bubble real estate - combined with excessive leverage. So they took a cursory look for me, and they pretty much confirmed my suspicions, but it is not straightforward. There conflicts of interest issues that goes far and wide. So much so, that I will most assuredly not be making anymore friends with this blog. Many of the financial professionals know this, but the layman may not.

    What's wrong with the ratings agencies?

    What's wrong with the ratings agencies? All of the major rating agencies feel MBIA is in good standing to weather the storm. Coincidentally, they all receive significant fees from the monolines and their customers. Hmmm! Now, there is this song by Kanye West, the rapper. A verse goes, "I'm not saying she's a gold digger…" Well, to make a long story short, any analysis born from compensation received from the entity you are analyzing will always be suspect, at least in my eyes. Conflicts of interest and financially incestuous relationships appear rampant to the paranoid conspiracy type (like me). If you remember my analysis of Ryland, I looked at data as far back as 1993. That gave a succinct, but barely acceptable snapshot of what to expect in turbulent times from a historical perspective. You would need much more data to analyze the more complex topic of MBS. It is believed by the naysayers, that the major ratings agencies have sampled data from only the good times, thus that is why their worst case scenarios still smell like roses. Their predictive prowess over the last few years doesn't look very impressive either. Massive swath of investment grade securities (that they, themselves, labeled investment grade - and were paid by the securities' issuers to do so) are being downgraded straight to junk. I know if I invested in AAA bonds that are losing principal and downgraded to junk in a year or two by the same rating that gave it an investment grade rating in the first place, I would be pissed. But, that is what happens without the proper due diligence, I guess. At least that is what the ratings agencies are bound to say. When looking at data gathered from the real estate boom, and not the busts, you get:
    ----- EXTENDED BODY:

    Data sets limited by favorable recent year trends

     

  • Low interest rates, which improving liquidity which allows bad risks to refi out of their situations
  • Rising home prices, which allow bad risks to sell out of their situations
  • Strong economic environment, allows for better earning power
  • Product innovation (hey, I can sell anything)
  • No payment shocks in existing (boom and bubble) data because borrowers have been able to refinance
  • Performance of securitizations benefited from required and voluntary removal of troubled loans

    Rating agencies assume limited historical correlation (20%-30% for sub-prime) will hold in the future (we've heard this line before) as the credit cycle turns (it is obviously turning now), correlations could approach 100%.

    Just imagine if the ratings agencies are as accurate with their opinion of MBIA as they have been with their opinions on the securities that MBIA insures. Look out below!!!

    Smaller advisories, coincidentally those that do not receive significant fees from the monolines and their customers, have a different take on the monolines. Take Gimme Credit, for example. Gimme Credit downgraded MBIA's bonds to "deteriorating" from "stable" earlier last week, citing the potential for write downs. They also stated that the other major agencies should have done so a while back. CDS market has also moved against the big monolines. I know everyone has an opinion, but the problem starts to look like a problem when you can prognosticate the opinions based on the incestuous nature of the money trail.

    Now, let's be fair to the big agencies

    To be fair to the big ratings agencies, they dance a precarious line. If they do downgrade the monolines, they, by default, downgrade all of the bonds and entities that they insure. That is not just mortgages and CDOs, but municipals, hospitals, etc. This ripples through various investment funds, government funds, the whole nine yards. Then again, it really doesn't look good when the companies that don't get fat fees from the insurers and their clients are so much quicker to downgrade than those that do. So they are damned if they do and damned if they don't. Then again, there a fair share of boutique research houses that say that it would take an extremely fat tail and near 100% correlation amongst the insured securities to cause failure in the monolines. Well, have you ever been to Tasmania? Tasmanian devils have very fat tails, as well as a whole host of other animals such as fat tailed skinks and occurrences with a 1 in 2 million chance of happening such as the outlier that took down LTCM. You see, when everyone is leveraged up, and there is one door when someone yells fire - it is going to get awfully crowded around that exit. Call it correlation, call it common sense, call it whatever, but I think we will soon be calling it a foregone conclusion. These fat tails don't have to be as fat as the financial engineers think they have to be. As for the 100% correlation, well that was briefly mentioned in the bullet list above, but from a common sense perspective, as the subprime underwriting really takes effect (what we have seen thus far is just the start), everyone in leveraged instruments (i.e. everyone) will start running for the exits at the same time - hence 100% correlation. I figured this one out without a model, nor a Financial Engineering PhD. I know there are those who disagree with me or may think that I don't know what I am talking about. Well, a few months will reveal one of us to be wrong. Somehow, I don't think it will be me.

    Relation between MBIA and Channel Re

    Channel Re is a Bermuda-based reinsurance company established to provide 'AAA' rated reinsurance capacity to MBIA. Renaissance Re Holdings Ltd, Partner Reinsurance Co., Ltd, Koch Financial Re Ltd and MBIA Insurance Corp are the investors in Channel Re. MBIA has a 17.4% equity stake in Channel Re and seeded Channel Re with the majority of its business. Channel Re has a preferential relationship with MBIA.

    Channel Re has entered into treaty and facultative reinsurance arrangements whereby Channel Re agreed to provide committed reinsurance capacity to MBIA through June 30, 2009, and subject to renewal thereafter. Channel Re assumed an approximate of US$27 bn (par amount) portfolio of in force business from MBIA Inc and has claims paying resources of approximately US$924 mn. (source Renaissance Re 10K. Swapping Paper Losses Channel Re is insulated against huge losses because of adverse selection in terms of pricing and risk on the assumed portfolio of MBIA. The agreement between the Channel Re and MBIA protects channel Re against any major losses. This financial reinsurance scheme smells a little fishy.

    Is MBIA dumping mark to market losses on Channel Re through reinsurance contracts?

    The SEC and the NYS Insurance Dept. thought so. In addition, there is overlapping risk retained through the relationship - MBIA has an equity investment of 17.4% in Channel Re. Channel Re assumes 52.37% of the total par ceded by MBIA of US$74 bn. The total par ceded not covered through reinsurance contracts due to the equity investment of MBIA in Channel Re is US$6.7 bn. Thus, there is a little under $7 billion dollars of risk that many think MBIA is covered for that it really is not. Then there is the case of diversity of Channel Re's portfolio. I have a slight suspicion that MBIA's business makes up much too much of it to be considered well diversified. Rennaisance Re, the majority owner, has also come clean admitting that Channel Re has a very high exposure to CDO losses and mortgage backed securities. Uh oh! This admission came from the extreme losses Channel Re took last quarter due to mark to market issues for mortgage backed paper. Again, is MBIA doing the old financial reinsurance scheme that was outlawed not too long ago? My gut investor's feeling tells me...For those not familiar with the reinsurance game, here is a primer on financial reinsurance

    Haven't we learned how dangerous leverage can be?

    Particularly when you don't have a firm grasp on the underlying collateral and risks involved

    Do you remember my exclamation of the incestuous relationships? There is the moral hazard issue of everyone getting paid up front except for the ultimate risk holder.

    Keep in mind, in terms of terms of the ratings agencies:

  • They only get paid of the deal closes favorably, and banks go ratings opinion shopping for the desired results - very similar to the residential real estate boom where brokers went shopping amongst appraisers to get the blessed number that they desired. Without that number, the appraiser/ratings agency just won't get paid.

  • Fairness opinion fees are only really not that synonomous with fairness, since the grand arbiter of fairness is the guy that paid to get the deal done in the first place.

  • Structured finance (like that of MBIA's business) is 40% of the rating's agencies' revenues and pay out considerably higher margins than the plain vanilla bond business

  • Reputational risk exists when opinions are changed quickly. They do not want people like me asking why a tranche can go from AA to CCC in a year!!! I think what companies such as Fitch are figuring out is that reputational risk exists in greater part when opinions are changed too slowly and are questioned by pundits publicly in the face of failure. I have noticed that Fitch has gotten much more aggressive than the other two major agencies.

  • There are several other reasons, which I won't go into here, which are bound to lead one to believe that conflicts of interests are rampant.

    So, if I am right, and the insurers are wrong, what happens as default rates increase?

    The 7 graphics immediately above are from the Pershing Capital Report linked above.

    Monoline insurers make a very unique counterparty. Unlike guidance of traditional ISDA contracts, and unlike traditional insurers, financial guarantors don't put capital up front, they don't post additional capital in the case of contract value decline, and need not post additional capital in the case of an adverse change in their credit rating.

    MBIA is woefully undercapitalized in the event of a major mortgage security default event, despite the opinions of the large ratings agencies. Look at the graph and use common sense.

     

    Image010

     

    As of Q3 of 07, they had approximately 35 basis points of unallocated reserve to cover net (of reinsurance, see the redundant risk through Channel Re note above) par outstanding financial guaranty contracts. Put in lay terms, MBIA, after buying reinsurance to cover itself for potential losses (some of which it has actually bought from itself), has 35 pennies to pay for every $100 of risk protection that it sells to its customers. This is cutting it thin, no matter which way you look at it. Particularly considering how reliably the subprime underwriting of the recent boom has caused defaults to occur, uniformly and with increasing correlation across multiple and historically disparate underwriting classes. Now, this 35 cents of protection coverage for every $100 of risk translates to extreme leverage. If you think the hedge funds took excessive capital risk due to leverage, you ain't seen nothin' yet.

     

    Image011

     

    MBIA easily sports 100x plus leverage for the last quarter or two.

    MBIA has increased exposure to Structured Finance during period of rapid innovation and lower lending standards. It's structured finance exposure has increased along with all of the other housing sector related companies during the boom, more than doubling in the last ten years.

     

    MBIA has significant capital at risk

    Source: Pershing Capital

     

    Source: Pershing Capital

     

    Source: Pershing Capital

     

    Being so sensitive and exposed to CDOs, one would be curious as to what happens if the CDO spreads widen. Well…

    Effect of Change in spread in CDO

       

    Figures in Million of dollars

       

    As of 31/12/2006

       

    CDO Exposure

     

    130,900

    Statutory Capital Base

     

    6800

         

    Assumed Duration of the CDO bonds

    5

     

    Change in Spread that can eliminate capital

     

    In bps

    104

     

    Capital Eroded

     

    6807

         

    Remaining Equity

     

    -6.8


    So, an increase of 104 basis points in CDO spreads wipes out the equity of MBIA, TOTALLY wipes it out.

    To put this into perspective, let me show you the entire sensitivity grid. Hey, no matter which way you look at, these guys are at risk. They have $6,800 in capital. Just move your finger over any combination of CDO duration and spread in basis points, and if you come close to that 6,800 figure, bingo! The current duration average is approximately 5 years. So the question is, "Will spreads reach 104, or more?" Well, look at the charts above that I posted from Pershing. Better yet, look at the subprime underlyings performance, which can be mimicked by the ABX from markit.com. Horrendous, indeed.

     

     

    Sensitivity Analysis

           
       

    Spread in BPS

    Duration

     

    100

    102

    104

    106

    108

    3

    3,927

    4,006

    4,084

    4,163

    4,241

    4

    5,236

    5,341

    5,445

    5,550

    5,655

    5

    6,545

    6,676

    6,807

    6,938

    7,069

    6

    7,854

    8,011

    8,168

    8,325

    8,482

    7

    9,163

    9,346

    9,530

    9,713

    9,896

    MBIA Valuation

    MBIA appears to have engaged in the all so popular share repurchase method of attempting to raise share prices when they don't have anything better to do with shareholder capital. They have authorized and pursued $2.4 billion worth of share repurchases and special dividends. This is unfortunate since one would believe that they need every dime of capital they can get. Did the "program" work? Well, let's see…

         

    FY2007

     

    FY2008

    All Figures in Millions of Dollars, unless othrerwise stated

     

    Mean Multiple

    High Multiple

    Low Multiple

     

    Mean Multiple

    High Multiple

    Low Multiple

    Tangible Book Value

     

    6,684

    6,684

    6,684

     

    7,513

    7,513

    7,513

                       

    Diluted number of shares

     

    128.7

    128.7

    128.7

     

    123.71

    123.71

    123.71

                       

    BVPS

       

    51.9

    51.9

    51.9

     

    60.7

    60.7

    60.7

                       

    Equity Value Per Share

     

    $22.7

    $30.1

    $16.2

     

    $24.5

    $33.6

    $17.5

                       

    Current Stock Price

     

    $35.2

    $35.2

    $35.2

     

    $35.2

    $35.2

    $35.2

    (Discount)/Premium to FMV

     

    55%

    17%

    117%

     

    44%

    5%

    101%

                       
                       

    Peers

                     
                       

    Name

    Ticker

    Mcap

    Price

    BVPS '07

    BVPS '08

     

    P/B '07

    P/B '08

     

    Ambac Financial Group

    ABK

    4,120

    26.39

    65.44

    74.538

     

    0.40

    0.35

     

    Assured Guaranty

    AGO

    1,570

    19.8

    34.33

    35.804

     

    0.58

    0.55

     

    The PMI Group

    PMI

    1,460

    13.12

    42.05

    43.57

     

    0.31

    0.30

     

    Primus Guaranty

    PRS

    420.8

    5.83

    10.05

    11.26

     

    0.58

    0.52

     

    Security Capital Assurance Ltd

    SCA

    918.34

    7.06

    22.647

    24.44

     

    0.31

    0.29

     
                       

    Average

               

    0.44

    0.40

     

    High

               

    0.58

    0.55

     

    Low

               

    0.31

    0.29

     

    Book Value includes the effect of derivative and foreign currency loss

    So, in a nutshell, despite the significant drop in MBIA's share price, it is still trading at a 55% premium to it's mean adjusted book value comparable price.

     

    MBIA Management Issues

     

    • Resigned (5/30/06): Nicholas Ferreri, Chief Financial Officer
    • Retiring (1/11/07): Jay Brown, Chairman of Board of Directors
    • Resigned (2/16/07): Neil Budnick, President of MBIA Insurance Co.
    • Resigned (2/16/07): Mark Zucker, Head of Global Structured Finance

    Is it me, or do they have a vacuum of experienced management approaching? Worse yet, did these guys know something that we should be aware of? After all, looking at the graphs below, the industry is going to run into some rought subprime underwriting times!

     

    Image015

     

    Subprime Exposure by Vintage Among the Major Monolines

     

    Image016

     

    Remember, the Toxic Waste Vintages are '05, '06 and 1st half of '07

    Source: S&P

     

    Is Europe next?
    A third of MBIA's revenues stem from abroad, primarily in Europe. Most of the action in Europe is in the UK PFI market. These bonds finance roads, schools, rail projects, tunnels and public buildings. Italy, Spain, Portugal and France are also on the bandwagon. Niche sectors such as non-conforming mortgages in the UK (and possible Spain) are particularly susceptible, primarily for the same reasons they are here in the US. Over building, overvalued housing stock (particularly the UK, Spain and Ireland), lax (subprime) financing, and declining property values under loose regulation. It definitely will not help the European insureds if MBIA gets downgraded or CDS spreads widen considerably.

Whether you have seen him featured on CNBC, The Keiser Report or are interested in the world of “smart contracts,” Reggie Middleton, the “Disruptor-In-Chief” of Veritaseum, is an expert you should know.

Based in the New York area, Middleton has gone from a successful real estate investor, capitalizing on the market’s economic downturn in 2008, to predicting the fall of Bear Sterns, Lehman Brothers, and others in the years to come. Reggie Middleton has always been a step ahead of the curve, so Bitcoin.com sat down with him on where the banking industry is going with blockchain technology.

As a former banker myself, I’ve seen many parallels with the Internet’s global propagation back in the 1990’s, and how the “banksters” are struggling with the Bitcoin concept, just like they did the Internet way back when. The rhetoric and blind attacks of today show history repeating itself if memory serves me correctly. How does Reggie see this financial industry-wide plan of blockchain integration playing out? Read on.

Bitcoin.com (BC): Haven’t we been through this before with banks trying to co-opt and centralize decentralized systems? Why will this be any different than ISDN or corporate Intranets from the 90’s?

Reggie Middleton (RM): Banks and many other private companies have tried to recreate the virtues of the internet via mini, private internet-like networks called intranets. These intranets were very useful and materially increased the utility of the banks, but they all paled, considerably paled in comparison to the value, utility, and ubiquity of the public internet. Click here for more on how this model works.

BC: You speak to the bankers fairly directly. What is their endgame with private blockchains, which leads to their altcoins? Disrupting the disruptor, Bitcoin? Is the goal to simply becoming more tech savvy and cost-efficient?

RM: Most in the evening industry don’t have an endgame in regards to Bitcoin technology – at least not yet. This is because they don’t fully understand its potential. They appear to be getting most of their education on the topic from a fairly narrow, undiversified set of sources. Hence, any potential misconceptions, biases or downright errors are easily reply ingrained, multiplied and propagated. If this continues for any meaningful amount of time, the re-education can be and likely will be quite painful if not lethal to the less light of foot.

"“Many of the bankers I’ve spoken to eschew Bitcoin and other ‘digital currencies’ […] don’t realize that the private blockchains use altcoins, the very same concept that they are eschewing in Bitcoin and cryptocurrencies.”

For instance, you mentioned altcoins. Many of the bankers I’ve spoken to eschew Bitcoin and other “digital currencies” (failing to realize that most USD and EUR are digital currencies, what they mean is crypto-currencies) don’t realize that the private blockchains use altcoins, the very same concept that they are eschewing in Bitcoin and cryptocurrencies. Worse yet, of all the cryptocurrencies in existence to date, Bitcoin is by far the most vetted. I feel many banks and bankers hear the hype and jump on the bandwagon without doing their due diligence. Time will tell if I’m correct in this assumption.

BC: Do you feel a small-medium sized banks will adopt decentralized digital currencies as a whole? And will this calculated breaking off from the establishment herd drive the industry in a new direction of Bitcoin inclusion?

RM: I think that either a relatively small or underprivileged bank will figure out how this stuff works (“Network effect” and all) and set off a chaotic chain reaction that will tear legacy business models asunder. There’s about a 30% chance of that outcome, in my opinion. The more likely outcome is a technology-oriented concern engineers this tech to disintermediate the banks to the extent that they’ll be rendered mere money pipe utilities needed for their banking charters (say a 60% chance of this outcome). The least likely outcome is the legacy banking industry gets it right, which has never happened before during any major paradigm shift, so leave a 10% chance for this. Click here for more on this.

BC: Do you think banks will make viable blockchains at all? Who says they can model Bitcoin’s success for their private gain?

RM: Banks will make private blockchains whether they will be viable or not is not only up for debate but also highly relative. If what you mean by viable is “Will it work?” Then I’d say yes. Now, if you mean by viable is “Will it be competitive with a widely accepted public blockchain?” then the answer is almost definitely no. You see, “Network effects” prevent private blockchains from ever scaling to the prospective heights of a widely accepted public blockchain such as bitcoin. Click here for more on this.

"‘Network effects’ prevent private blockchains from ever scaling to the prospective heights of a widely accepted public blockchain such as bitcoin.”

BC: Can banks have it both ways? Deriding the bitcoin digital currency while praising its technological foundation? Is this genius, or basic hypocrisy?

RM: Attempting to laud the blockchain while deriding tokens that make them work is neither genius nor hypocrisy. In my opinion, it’s ignorance. Picture me saying, “ I love this Internet thing, but want nothing to do with Internet packets. Unfortunately, only nerds will get that one. For more on this, go here.

BC: Was Jamie Dimon right? Will the government, or some higher power, prevent Bitcoin from going viral in the mainstream, at least in Western civilization?

RM: Jamie Dimon is talking “his book.” He’s talking like a bank CEO, who is expected to say pro-bank things, and slam things that will compete with bank offerings. He’s simply doing his job. Now, please remain cognizant of the fact that this does not mean that he necessarily knows what he’s talking about, nor is he necessarily speaking the truth.

"If bitcoin is outlawed, one risks driving it underground. Governments don’t want tech that they can’t control nor stop driven out of its reach.”

The fact that the US, the world’s most powerful financial concern, has not banned bitcoin should tell you something. If bitcoin is outlawed, one risks driving it underground. Governments don’t want tech that they can’t control nor stop driven out of its reach. That is exactly what will happen if it goes underground as a peer to peer system. Think of how successful the MPAA, the record industry, and the courts have been in stemming the use of peer to peer file sharing of MP3s after their massive legal assault? Hint: over 60% of download Internet traffic is thought to be P2P torrent-style downloads.

The can easily happen to the banking industry. The path of least resistance is to regulate and then attempt to co-opt Bitcoin (think IRS and NSA) then to outlaw and attack outright.

As for his opinion on virality, methinks he may be missing the point? Viral outbreaks are never, never anticipated, wanted nor prevented by those who are subject to it! That’s not a matter of choice!

BC: Please sum up banking, blockchains, and privatization for us. Is this a net-positive for the Bitcoin community just based on the publicity alone?

RM: My summation will likely be different from what you’d expect. I believe that the entire banking community and many of the entities that are serving them are headed in the wrong direction, re Bitcoin technology. Everybody is reaching for the low hanging fruit, totally disregarding why said fruit is hanging low in the first place (hint: it’s fully ripened and is about to drop off the vine). Very wide area networks (vWANs, such as the Internet) were designed to be used by as many entities as possible (not a select group).

This is where the network effect comes into play, and how a publicly accepted Bitcoin network will force banks to play ball in its arena or face extinction. You see, Bitcoin not only enables autonomous activities, but it also rewards them. The legacy banking business model, as we know it today, is predicated on a heteronomous business model. So was the music industry before the Internet. How did that work out for them?

This is part 2 of the Municipal Bond Market and the Asset Securitization Crisis, continuing the primer listed as number 5 in the series below. It is to provide a background for the increase in stress and pressure in the monoline industry, which I believe has a strong chance of creating a CDS domino effect throughout the investment banks and other insurers. For more info on the risks and threats of the CDS market see Counterparty risk analyses – counterparty failure will open up another Pandora’s box. See "I know who's holding the $119 billion dollar bag" for a listing of the most likely candidates to suffer, as well as Banks, Brokers, & Bullsh1+ part and Banks, Brokers, & Bullsh1+ part 2 for my take on the general risks in the investment banking industry today. Reggie Middleton on the Street's Riskiest Bank - Update drills down on one of my short positions to reveal why I am bearish on Morgan Stanley - way before the sell side started yelling sell may I add, very similar to the contrarian position taken in Bear Stearns late last year.

The following municipal bond portion of the asset securitization crisis is also a tie-in to the prospects of the monoline insurance industry. The latest of my monoline analyses is the Assured Guaranty Report. You can also peruse the work I did on MBIA and Ambac starting from the inception of my short position in these companies last year, which turned to be nearly as profitable as the Bear Stearns short (see Is this the Breaking of the Bear?) instituted late last year as well, and based on the same investment thesis. A quick background of my older musings on the monoline industry:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses throughout Wall Street and Main Street

Thus far in the Asset Securitization Crisis Series, we have:

  1. 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
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. Municipal bond market and the securitization crisis – part I
  6. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
  7. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  8. More on the banking backdrop, we've never had so many loans!
  9. More HELOCs, 2nd lien loans, and rose colored glasses

Municipal Bond Defaults

Further building on the municipal bond default analysis Part 1, we have calculated the likely default amount on the municipal bonds issued in the last four years (2004 to 2007). We have assigned default rates on the municipal bonds for various states on the basis of property price decline and the decline in the building permits witnessed in each state. In this analysis, we have also considered defaults on the general obligation bonds (GO bonds) as the macroeconomic conditions have deteriorated and could result in increased stress on municipalities. Although historically, the GO bonds have defaulted rarely (the contribution to total default by Municipal bonds is 3.54% for GO bonds and the remaining 96.46% defaults is on Revenue bonds), declining property prices and rising foreclosures are likely to have a negative impact on municipalities’ revenues in the form of taxes.

 

Since we have maintained from the beginning that this crisis is far worse than any crisis that the US economy has witnessed for close to half a century, our underlying assumption while calculating the default probabilities by GO and Revenue bonds has been a premium over historical default rates on the munis for the period 1979-97. This premium is dependent on the degree of decline in housing prices, building permits and the broader infrastructure investment. In the case of Revenue bonds, the multiple has been considered higher as compared to GO bonds since historically; Revenue bonds have defaulted more than the GO bonds.

 

House price decline

Building permits decline

Premium over historical defaults forRevenue bonds

Premium over historical defaults forGO bonds

-5%

-10%

1x

1x

-10%

-20%

2x

1.5x

-15%

-30%

3x

2.0x

> -15%

> -30%

4x

2.5x

 

We have calculated the likely defaults on municipal bonds issued since the year 2004 since this is the period where most US state and local governments had prepared budgets based on the existing real estate boom. In addition, the prevailing low interest rate environment was very conducive for muni bond issuance. However, with the collapse of the housing market, property values went down and increasing numbers of homeowners applied for the property revaluation to reduce their property tax burdens. This increased the burden on the respective municipalities, as homeowners, in an attempt to mitigate the increase of their financial obligations obtained during the housing boom equity spending spree, cut corners by any means necessary. Construction permits and the associated fee income dropped precipitously, further constricting the bloated budgets of municipalities who, like the fabled subprime refinancing, SUV driving 1st time homeowner binged on easy equity-sourced cash.

Additional strains in the revenue sourcing for municipalities are the rampant foreclosure rate increases and the actual volumes of foreclosures. Up until the event of actual foreclosure, property taxes are usually not paid, further hampering the cash flows of municipalities that relied on these funds. It gets worse. Even after foreclosure, and even on behalf of the municipality, the back taxes cannot be monetized and actually paid until the property is sold. Many auctions in high foreclosure areas are seeing properties with no bid at the upset price. This portends very bad things for the banks, the municipalities and the insurers who wrote insurance to cover them!

 

These developments are likely to have a severe negative impact on the tax inflow for the state and local governments which forms the basis of our underlying assumptions. According to our estimates, on the total municipal bond issuance of US$1.6 trillion in the year 2004-07, the potential losses due to defaults will be US$22.8 billion or a default rate of 1.44% with Revenue bonds contributing majority of the default amount of US$22.5 billion while GO bonds account for US$304 million. This indicates a default rate of 2.12% for the Revenue bonds and 0.06% for GO bonds.

 

Multi family housing and healthcare led the defaults in municipal bonds

Historically, housing and healthcare sectors have been the biggest contributor to municipal defaults (after the industrial development bonds which account for 24% of defaults). In housing, the multifamily segment has recorded maximum losses accounting for 19.3% of total defaults while single family accounts for 1.1%. In the healthcare sector, hospitals and nursing homes accounted for majority of defaults of 7.5% and 7.1%, respectively.

 

Default rates in municipal bonds have varied significantly across the subsectors. The defaults in the tax-backed, water/sewer, and other plain vanilla municipal bonds has been significantly low. According to Fitch Ratings (the only of the big ratings agencies that can garner even the slightest modicum of respect these days), the cumulative default rates on such bonds have been less than 0.26%. However, default rates in municipal bonds issued on behalf of corporations or municipal entities were significantly higher. Historically, the cumulative default rates were 14.9% for industrial development bonds, 4.9% for multifamily housing, and 2.6% for health care.

 

Industrial development bonds, multifamily housing and healthcare sector’s accounted for 8% of total bond issuance and 56% of total defaults while education and general purpose sectors accounted for 46% of issuance and 13% of defaults.

 

Multifamily housing defaults

Multifamily housing defaults peaked in 1991 as the US economy went into recession and then again in 1998 the defaults soared as the economy faced stress during that period with the collapse of LTCM and the subsequent dotcom bubble burst. This denotes difficult market conditions manifested as defaults, as witnessed in 1991 when multifamily defaults soared. The current housing market scenario featuring historically severe declining home prices and home sales and rising foreclosure rates portends an equally historic hit to the multifamily housing segment that could witness a surge in defaults that this country has not seen thus far.

 

Multi family housing defaults (by year of default)

Year

No. of Defaults

DefaultedAmount

(US$ million)

Avg. Time to Default

Rated entity

Non-Rated entity

1990

13

94

60

2

11

1991

33

1,359

55

24

9

1992

17

200

66

11

6

1993

17

85

67

3

14

1994

5

41

82

2

3

1995

5

33

88

1

4

1996

9

39

97

2

7

1997

10

44

64

0

10

1998

26

102

55

6

20

1999

18

52

56

0

18

Totals

153

2,050

63

51

102

 

 

In the multifamily housing segment, default rates increased significantly and were extremely high for the period 1987-90, i.e. at the time of the S&L crisis when real estate lending was reckless due to declining lending standards by banks and other financial institutions. The default rate peaked in 1988 in the eleven year period reviewed to 4.31%, followed by 3.41% in 1989. However, the overall default rate for multifamily housing sector is 1.11% for the 11 year period (1987-1997).

 

Multifamily housing default rates by year of issuance (1987-1997)

Issuance year

No. of defaults

Total issues

Default rate (by no of issues)

Defaulted amount (US$ million)

Total amount issued (US$ million

Default rate by amount

1987

7

182

3.85%

50

2,961

1.70%

1988

14

202

6.93%

137

3,180

4.31%

1989

16

237

6.75%

106

3,110

3.41%

1990

8

240

3.33%

64

3,062

2.09%

1991

2

277

0.72%

23

3,561

0.63%

1992

6

400

1.50%

33

5,733

0.58%

1993

13

517

2.51%

68

6,614

1.03%

1994

7

501

1.40%

16

4,930

0.33%

1995

9

603

1.49%

27

6,132

0.44%

1996

10

607

1.65%

35

6,638

0.52%

1997

5

606

0.83%

9

5,412

0.17%

Total

97

4372

2.22%

568

51,333

1.11%


Defaults in healthcare

In the healthcare sector nursing homes accounted for majority of defaults at approximately 49%, followed by the retirement sector (29%) and hospitals (12%) based on the number of defaulted issues. However, on the basis of default dollar amount, retirement and hospitals take the lead over the nursing subsector.

 

Healthcare sector default break up

Subsector

number of defaults

default amount

Default rate(%) based on number

Default rate(%) based on amount

Nursing

116

454

48.5%

22.8%

Retirement

70

568

29.3%

28.5%

Hospitals

29

546

12.1%

27.4%

Other

24

426

10.0%

21.4%

Total

239

1,994

100.0%

100.0%

 

Total Health care sector number of defaults and default amounts

Year

No. of Defaults

Defaulted Amounts US$ million

Avg. Time to Default

Rated entity

Non-rated entity

1990

40

299

51

3

37

1991

31

128

67

4

27

1992

18

224

56

5

13

1993

18

220

57

0

18

1994

8

33

52

1

7

1995

13

40

70

0

13

1996

17

218

77

3

14

1997

17

112

77

0

17

1998

18

152

47

0

18

1999

59

567

48

8

51

Total

239

1,994

58

24

215

 

The healthcare sector has witnessed significant stress during the 1990-91 period resulting in increased number of defaults owing to recession in the US. The bond defaults of the Graduate Health System accounts and the Michigan Healthcare Corporation resulted in higher defaults in 1990 period.The healthcare sector again witnessed increased strain in 1999 driven by increased failures on the part of nursing homes and hospitals. In May 1999, Greater Southeast Healthcare System filed for bankruptcy protection and suspended payments on its $46 million of outstanding bonds. In addition, the bonds issued for Graduate Health System in the Philadelphia-area accounted for $155.94 million of the defaulted amount in 1999. The healthcare sector witnessed significant strain across all its subsectors which saw the default amount rose to very high levels of US$567 million.

 

Decline in building permits

Significant decline in building permits has been witnessed in California, Florida, Alaska, Arizona, Georgia, Nevada, Michigan, Minnesota, Ohio and Oklahoma in the last few years. Most of the US states are witnessing the decline in building permits as the construction sector strives to stay afloat in the midst of what predict to be the worst US housing crisis, period. Up until March 2008, the building permits have declined at a rate significantly higher than that witnessed in earlier years with states such as Arizona, California, District of Columbia, Florida, Georgia, Idaho, Illinois, Kentucky, Massachusetts, Michigan and Minnesota witnessing 50% or more declines in building permits. The building permits have declined at a CAGR of 19.5% in the US in the last two years (2005-2007). In the state of California, Riverside, San Bernardino, Ontario, Sacramento and Yuba City are witnessing significant decline in building permits. In Arizona, Phoenix, Mesa Scottsdale and Tucson are the areas with significant decline in building permits. In Florida, Orlando, Punta Gorda, Sarasota, Brandenton, Venice and Cape Coral are the areas witnessing decline in construction activities. To make matters worse, declining property prices in these states are likely to hit the states’ finances. According to S&P Case-Shiller index, property prices declined 2.6% in February 2008 from a month earlier, after a 2.4% decline in January 2008.

 

* 2008 (A) building permits represent the YTD March 2008 annualized figure.

 

Building permits change

States

YTD2008

2007

2006

2005

2004

Alabama

-28%

-19%

5%

12%

23%

Alaska

-50%

-38%

-5%

-8%

-11%

Arizona

-55%

-24%

-28%

0%

21%

Arkansas

-24%

-21%

-23%

13%

7%

California

-49%

-31%

-22%

-1%

8%

Colorado

-30%

-23%

-16%

-1%

18%

Connecticut

-10%

-16%

-22%

0%

13%

Delaware

-30%

-19%

-21%

4%

1%

District of Columbia

-82%

-9%

-26%

48%

36%

Florida

-44%

-50%

-29%

12%

20%

Georgia

-52%

-30%

-5%

1%

12%

Guam

         

Hawaii

-51%

-7%

-23%

9%

24%

Idaho

-51%

-29%

-21%

19%

20%

Illinois

-55%

-27%

-12%

12%

-4%

Indiana

-40%

-18%

-24%

-2%

0%

Iowa

-32%

-16%

-20%

3%

2%

Kansas

-6%

-22%

4%

6%

-12%

Kentucky

-47%

-10%

-21%

-6%

11%

Louisiana

-6%

-18%

26%

-1%

3%

Maine

-39%

-19%

-19%

2%

11%

Maryland

-24%

-20%

-23%

10%

-8%

Massachusetts

-50%

-22%

-20%

9%

11%

Michigan

-44%

-39%

-36%

-17%

1%

Minnesota

-48%

-32%

-28%

-13%

0%

Mississippi

-28%

1%

24%

-8%

21%

Missouri

-36%

-26%

-12%

1%

12%

Montana

-39%

-9%

-5%

-3%

32%

Nebraska

6%

-8%

-17%

-9%

6%

Nevada

-49%

-31%

-17%

7%

3%

New Hampshire

-23%

-20%

-25%

-12%

0%

New Jersey

-8%

-26%

-11%

7%

9%

New Mexico

-27%

-32%

-4%

13%

-9%

New York

-39%

-1%

-12%

16%

8%

North Carolina

-30%

-14%

2%

5%

17%

North Dakota

3%

-5%

-13%

0%

8%

Ohio

-37%

-21%

-28%

-8%

-3%

Oklahoma

-26%

-7%

-14%

8%

14%

Oregon

-49%

-21%

-14%

14%

9%

Pennsylvania

-25%

-14%

-12%

-10%

5%

Puerto Rico

         

Rhode Island

-56%

-18%

-16%

12%

11%

South Carolina

-36%

-20%

-6%

25%

13%

South Dakota

-38%

-4%

-7%

-3%

17%

Tennessee

-37%

-19%

-1%

4%

19%

Texas

-19%

-18%

3%

12%

7%

Utah

-54%

-22%

-7%

15%

8%

Vermont

-38%

-22%

-10%

-19%

26%

Virginia

-12%

-20%

-22%

-3%

13%

Virgin Islands

         

Washington

-41%

-5%

-6%

6%

17%

West Virginia

1%

-15%

-8%

7%

11%

Wisconsin

-33%

-20%

-23%

-12%

-2%

Wyoming

-29%

29%

-12%

21%

18%

 

Looking at this through a graphic representation puts things into perspective. Notice how far below the zero line this graph is in just one year!

 

Decline in property prices led by California, Florida and Nevada

The property prices in the US continue to witness significant decline since reaching record levels in 2005. The distressed home owner, having leveraged his or her appreciated home value during the peak of a bubble combined with deteriorating mortgage credit quality (increased Alt-A and subprime mortgages), has increased the intensity of the current crisis. The decline in US home sales has dwarfed the previous housing declines as conditions continue to worsen, depicted by declining building permits and home prices. Rising housing inventories, increased foreclosure, declining home prices, and the correction in home sales volumes are likely to make matters much worse.

 

US home prices continued thier downward foray as reported by Office of Federal Housing Enterprise Oversight (OFHEO) through a reported decline of 1.7% in 1Q 2008 as compared to 4Q 2007. The fall surpassed the 1.4% sequential decline witnessed in 4Q 2007. The OFHEO’s Index recorded its largest y-o-y decline in the last 17 years with a drop of 3.1% in 1Q 2008. California, Nevada and Florida witnessed the steepest y-o-y declines in home prices. The states of California, Nevada, Florida, California led the fall depreciating by 10.6% followed by Nevada 10.3%, Florida 8.1%. The metropolitan areas witnessing steepest decline are Merced (down 24.7%), followed by Stockton (down 21.5%) and Modesto (down 21.0%), all in California. According to the OFHEO, 43 states witnessed price decline in 1Q 2008 wherein in the prices fell by more than 3% in eight states and more than 8% in two states, namely California and Florida. California, which derives 22% of state revenue, including both state and local government from property taxes continues to witnessing significant decline in building permits and housing prices. It is worth noting that California was one of the states that created significant budget bloat during the boom times of the RE bubble, which serves to further exacerbate the problems at hand.

Decline in housing starts and home sales (existing and new)

Housing starts as well as the existing and new home sales have declined significantly since the beginning of 2005 across the country with the West and Midwest states the most severely affected.

 

New home sales (% change)

Year

North EAST

MID WEST

SOUTH

WEST

2004

       

2005

-2%

-2%

14%

3%

2006

-22%

-21%

-12%

-25%

2007

3%

-27%

-26%

-32%

 

Existing home sales (% change)

Year

North EAST

MID WEST

SOUTH

WEST

2004

       

2005

2%

2%

6%

3%

2006

-6%

-7%

-4%

-17%

2007

-8%

-10%

-13%

-20%

 

 

In addition the annual housing starts have declined significantly across the country. In 2007, the overall US housing starts have declined 24.8%, followed by a 12.9% fall in 2006.

 

Total Annual Starts

2002

2003

2004

2005

2006

2007

United States

1705

1848

1956

2068

1801

1355

% increase/(decrease)

6.4%

8.4%

5.8%

5.7%

-12.9%

-24.8%

Northeast

159

163

176

190

167

143

% increase/(decrease)

6.7%

2.5%

8.0%

8.0%

-12.1%

-14.4%

Midwest

350

374

355

358

279

210

% increase/(decrease)

6.1%

6.9%

-5.1%

0.8%

-22.1%

-24.7%

South

781

838

908

996

911

682

% increase/(decrease)

6.7%

7.3%

8.4%

9.7%

-8.5%

-25.1%

East

416

473

516

525

444

320

% increase/(decrease)

6.4%

13.7%

9.1%

1.7%

-15.4%

-27.9%

 

These statistics fully support my assertion that as the current market situation continues to worsen, the potential losses and defaults on municipal bonds could be – and probably will be, much higher than estimated by the majority. This portends considerably more stress than anticipated by the stress testing models employed by the monolines and the rating agencies that rate them. It is not as if I have had much confidence in their predictive ability to gauge risk, considering how bad they have performed in the mortgage sector over the last two years and the public admittance of software glitches and algorithms that assumed perpetual house price appreciation (that is housing prices that go up forever without even one downturn, not to mention a protracted downturn). This analysis should be read against the backdrop of:

The Asset Securitization Crisis Series

The Commercial Real Estate Crash Series

the Assured Guaranty Analysis

and the Riskiest Bank on the Street Update.

Next in this series is an overview of leverage and risk of the 32 Banks in Deep Doo-Doo.

I have identified 32 banks that are $@%%. It's really as simple as that. I have been publishing the research that I used to build my investment thesis. Thus far we have:

  1. 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
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. Municipal bond market and the securitization crisis – part I
  6. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital PNC addendum Posts One and Two
  7. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  8. More on the banking backdrop, we've never had so many loans!

 

I am almost prepared to start listing more of my commercial banking shorts, but before I do I want to delve even further into the educational realm so there is no doubt as to why I am as bearish as I am. For those who can't wait to see my ultimate shorts, I will give you the complete list of what I call the "Deep Doo-Doo Banks". These are the banks that are steeped pretty deep in it. Are you ready? Can you handle the pressure? Okay, here we go!

Wells Fargo - Popular Inc - SunTrust - KeyCorp - Synovus Financial Corp - Marshall & Ilsley - Associated Banc - First Charter - M&T Bank Corp - Huntington Bancshares - BB&T Corp - JPM Chase - U.S. Bancorp - Bank of America - Capital One - Nara Bancorp - Sandy Spring Bancorp - PNC - Harleysville National - CVB Financial - Glacier Bancorp - First Horizon - National City Corp - WAMU - Countrywide - Regions Financial Corp - Citigroup - Wachovia Corp - Zions Bancorp - TriCo Bancshares - Fifth Third Bancorp - Sovereign Bancorp

Now, I already release some of my work on one of the banks, chosen due to paper thin capitalization - along with a different view on leverage. Keep in mind, for the purposes of this blog, I'm just a resourceful individual investor - albeit one that is very lucky to date (this post was before Bear Stearns dropped 98%). Therefore, no one, and I really mean no one, should be taking my opinions on this blog as investment advice. It is not intended as such and should not be percieved as such.

Before we focus on which banks I am shorting, let's explore the current banking environment. I aimed my team at banks that have high concentrations in risky products, risky geographic areas and low tangible and regulatory capital. There were a lot to choose from. So, to narrow down the list, I had everybody enter the 12 step program - after reading my tutorials above, of course.

2nd lien products in high LTV states that have rapidly declining housing values proffer the opportunity for 100% losses with no recoveries.

>

Above is a list of states and the home equity and 2nd lien defaults for said states. For those who don't know, 2nd lien loans (of which include HELOCS, piggy backs, home equity loans, etc.) are 2nd in line when it comes to liquidation rights under foreclosure. If the loan was made with a high LTV (let's say 90% combined LTV, with the first loan made at 85% LTV), in an area that has even a modest (these days, anyway) decline in value of 10% year over year, then you effectively have a 100% loan with not equity. Every dollar after this that the house drops is a permanent loss from the bank's loan. Factor in the costs of deed transfer, mortgage tax, utilities, upkeep, brokers commissions and legal fees (about 7.5%), and the bank now get's nothing, even if it can move at auction. When I say nothing, I mean nothing. Not just an NPA on its books, but absolutely not way to recover any value from the home. I can hear the blog readers now saying, "Well, what are the chances of that happening?". Stay tuned, and we will assuredely find out.

The graph above shows a subsection of my 32 bank Deep Doo-Doo list who sport:

  1. HELOC portfolio exposures with high average LTVs that increase the risk of the whole portfolio
  2. HELOC portfolio exposures with full 100% LTVs or close to it consisting of a very large portion of the total portfolio
  3. HELOC exposures with very high, but not quite 90% LTVs consisting of a large portion of the total portfolio

 

For those that really wondered whether the scenario that I outline above could really take place - well, wonder no more! We have a whole smorgasbord of banks in that position. The key is, which of these bank have loans in the aforementioned areas detailed in the first graph. I know you know that I know the answer to that question. I'm even going to tell you for free, but before we go there let's cover some additional background material. I want you to pay particularly close attention to who is leading the pack in high LTV concentrations. I was short this bank and WaMu since last year, and have since covered both short positions in the single digits are close to it. As a rule, I rarely ride a stock past $10 on the way down because zero is but so far away and the risk/reward ration is rarely justifiable (the two monolines that I have covered in detail are an exception to this rule). In this case, I covered both too early, particularly Countrywide. The moral to the story here is that many of these banks are not too far behind Countrywide, with the largest difference between CFC and them being CFC's piss poor public relations ability. WaMu is right there too, as well as some big name banks with some big name investors behind them. I will end my bank series with a full scale forensic report of my number one short in the sector and I am sure it will shock many of you who like to buy into brand names.

In order to determine how likely the aforementioned event is, let's create a metric by which Reggie Middleton measures risk. This metric will be units of risky or non-performing assets as a percentage of statutory equity. This, of course, can be refined by removing goodwill, Bullsh1t, and the various accounting pollutants to plain old economic earnings, but less just start with this. When applying Reggie's Risk Metric to the graphs above, we can identify more banks.

Looking at risk from this perspective, we not only see who has no clothes on when the tide goes out, but also how well (un)endowed they are in addition.

Please keep in mind that some loans and banking products are much riskier than others. Due to this, I have culled what I believe to be the riskiest products to short list the banks. We have already addressed 2nd lien loans. There is also construction and development (C&D) loans that are still on the books that are by far, much riskier than the conventional commercial loans - which are risky assets themselves in this environment. An off the cuff, anecdotal assumption would be that 20% of these loans will be in default in many areas, with greater numbers the newer the vintage. For a category such as high rise condos, they are usually 24 month, interest only, 20-30 year amortization. The intent is to have them refinanced into permanent loans upon construction completion, which is difficult for projects such as condos. Construction costs have spiked, supply is up and demand is down. Those banks with high LTV C&D loans (ex. Corus Bank) and any 2nd lien loans over 90 LTV should be high on the short list. One to four family properties are also quite risky, for amateur (and not so amateur, actually) investors bought buildings without a firm (or even loose) understanding of cash flows, cap rates, and rental yields - aided and abetted by the banks which apparently missed out on the cash flow valuation memo as well. Well, those who overshot the predictions of rent rolls, undershot the estimation of expenses, or took out volatile ARM products ended up not only underwater, but with negative cash flow as well. It is much easier to walk away from an investment property than it is to do so from your home. As you can see from the graph below, my assertions seem to be ringing true. The rate of change in delinquencies in these are SKYROCKETING!

I am going to cut this short here, and will continue this series in 24 hours or so. I have quite a bit of information, so the series will be at least 4 or 5 additional parts. I also need to post my homebuilder updates (remember I broke the secret on the industry's secretive JV accounting) and Muni default ->CDS failure connection research as well. So much to do, so little time. I do hope you guys appreciate this, for I don't know where else to find it on the net. As if this disclaimer is necessary: I am short, or in the process of accumulating bearish positions in most if not all of the companies detailed in this article. See you in 24 (or so) on the boombustblog.com.

 

 

Before I get started, I want all to realize that this is not Goldman bashing piece. I think it is a [relatively] well run company, but its PR machine appears to be from Kindergarten land, and the aura of invincibility that it enjoys(ed?) is highly undeserved, as a consequence its historical "aura-based" premium is absolutely unjustified. Case in point...

On December 8th of last year, I penned "Reggie Middleton vs Goldman Sachs, Round 1"wherein I challenged all to take a critical look at exactly how much money was lost by Goldman Sachs' clients. Well, here comes round 2, which is directed at Goldman (over)valuation.

Three months ago I explicitly warned my readers and subscribers about how outrageously priced Goldman Sachs was: Get Your Federally Insured Hedge Fund Here, Twice the Price Sale Going on Now! Monday, 19 October 2009.. Goldman was closed at $186.10 that day.

Although GS' had beaten street expectations (which everyone at BoomBustblog.com should recognized as the game that it is), the company's share price has significantly run ahead off its fundamentals. Since December 2008, the company's tangible book value per share has increased by a modest 3.2% while its share price has increased by a whopping 92.1% with its Price-to-Tangible Book value per share ratio currently standing at 1.77x compared with 1.45x in 2Q09 and 0.45x in 4Q08.  Based on closing price as of October 18, 2009, GS' price-to-tangible book value per share is at 1.99x while average price-to-tangible book value per of its peers stood is 1.55x,implying a premium of 28% for the Goldman Sachs brand name. As I said, an expensive, federally insured, publicly traded hedge fund with a strong lobby arm and an even stronger brand management department.

Readers should take into consideration that this is the exact same argument that I posed a year and a half ago when I first shorted Goldman Sachs at $185! Where is it trading today? $186.43. This is after it had to be rescued by the government for fear of collapse!

Let's revisit history with an excerpt from Saturday, 05 July 2008, it's deja vu all over again...

I rode Goldman down to the $100 to $75 band, but it eventually bottomed somewhere around $50. Now it's right back where it started from, pre-bailout. Does it deserve to be there??? Inquiring minds want to know...

I consequently wrote "It appears as if the patina on Goldman's Stock is fading..." wherein I stated on the 15th of December (Goldman traded at $162.70):

"The amount of public resentment, potential for political backlash (yes, even Goldman can get stabbed in the back when a sacrificial lamb is needed), surfacing compensation issues (remember, on the Street, compensation is everything - there really is no company loyalty) and unwarranted premium added to this company's share price over the last few quarters appear to be culminating into another potential collapse in the company's share price. This is not investment advice, simply an anecdotal opinion.

I believe the Goldman premium will be reduced, along with its transient above market earnings potential/advantage (when the edge that it has is assimilated into the market). It probably cannot maintain its trading record for more than a few quarters (98% profitable days of trading out of a month is statistically impossible, but that is a story for another day), and its other value drivers still don' t look very promising. Last but not least, there is the matter of all of that trash still on the balance sheet. If the market's euphoric bear rally breaks, which it looks like it may (finally), then Goldman will break along with it. It has a long way to fall if it does."

Well, here we are on Jan 30th, 2010. Goldman's last closing price was $148.72, down 20% and primed to test their 52 week lows. Let's take a closer look at Goldman's last quarter then remind subscribers why they pay for my services. After all, just like in 2008, not one was talking about shorting the indestructible, government protected, almighty, infallible, uber-bailed out Goldman at their highs besides me (twice).

Reggie on Goldman's Q4 2009

My blog subscribers can download the full quarterly review and opinio here:  This reveiew has an updated valuation componet for Goldman, takng into consideration what we feel the stock is worth now, and also what could potentially happen if the market continues to slide further and signficantly. See

Non-subscribers (which, you all should be subscribers, but I'll forgive you for now), take note of this excerpt and screen shot from the subscription report.

With trading revenues dictating the overall profitability of investment banks like Goldman Sachs, important concerns are being raised about the business models of investment banks which are highly dependent on the trading income (highly volatile under current conditions) to sustain their profitability. Trading revenues (nearly 64% of the total net revenues in FY09) form a substantial portion of Goldman’s revenue stream and movements in this income stream determines the Company’s total revenues overall profitability. In 2009, trading revenues amount to nearly 63.9% of the total net revenues while the impact on earnings is magnified with the total trading revenues amounting to 145.6% of the total pre-tax income.

Comparing with the peers, the trading revenues accounts for highest percentage of total revenues in case of GS. The Company’s trading revenues are largely driven by the activity levels as well as spreads, both of which are market determined and decided by general macro-economic conditions. With nothing more uncertain than the macro-economic conditions and markets in US, this income stream is becoming increasingly volatile under the current circumstances. The future sustainability of this income is further dented by Obama’s recent policy announcements to curb proprietary trading (trading with no client related transaction involved and primarily done to earn profits by assuming greater trading risk). The administration is working out increased restriction on the risk-taking involved in earning prop trading revenues. The government is also planning to put restrictions on hedge funds and private equity transactions which will directly impact the revenues from Principal Investments of Goldman Sachs. Thus, apart from the risk of regulatory move that can seriously clamp down the trading revenues, the risk of deterioration in the general market condition, increase in volatility or a serious dislocation like the one witnessed in 2008 seriously undermine the future profitability of GS.

Click to enlarge full screen.

This multiple summary and graphs above also explains how Obama effectively cut the compensation GS, and to the lesser extent, othe banks employees. They are getting stock at the peak of a banking bubble - particularly after the most recent run up. I know I have heard pundits and analysts across the media saying that employees are getting discounted stock, but it is stock discounted off of a bubble at a time when banks are about to become worth a lot less - that is unless they find a way to do something else that is very productive contributory to growth (other than theirs) to replace extant yet dwindling revenue streams. Just take a look at the facts and figures above. They don't lie!

So, what is GS if you strip it of its government protected, name branded hedge fund status. Well, my subscribers already know. Let' take a peak into one of their subscription documents Goldman Sachs Stress Test Professional2009-04-20 10:06:454.04 Mb- 131 pages). I believe many with short term memory actually forgot what got this bank into trouble in the first place, and exactly how it created the perception that it got out of trouble. The (Off) Balance Sheet!!!

Contrary to popular belief, it does not appear that Goldman is a superior risk manager as compared to the rest of the Street. They may the same mistakes and had to accept the same bailouts. They are apparently well connected though, because they have one of the riskiest balance sheet compositions around yet managed to get themselves insured and protected by the FDIC like a real bank. This bank's portfolio looked quite scary at the height of the bubble.

You know what most people don't realize is that it looks quite scary now as well.

If one were to strip out the revenues from prop trading, it would leave bards some balance sheet issue. Again, I query, should virtual hedge funds that pay out half of revenue as compensation trade at such high premiums to the rest of the market? I don't think so, and I have put my money behind the idea that the market will not think so in the near future either.

 

More of Reggie on Goldman Sachs

Free research and opinion

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

Reggie Middleton's Goldman Sach's Stress Test: Breaking Ranks with the Crowd Once Again!

Who is the Newest Riskiest Bank on the Street?

More remium Stuff!

I have warned my readers about following myths and legends versus reality and facts several times in the past, particularly as it applies to Goldman Sachs and what I have coined "Name Brand Investing". Very recent developments from Senator Kaufman of Delaware will be putting the spit-shined patina of Wall Street's most powerful bank to the test. Here is a link to the speech that the esteemed Senator from Delaware (yes, the most corporate friendly state in this country). A few excerpts to liven up your morning...

Mr. President, last Thursday, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a 2,200 page report about the demise of the firm which included riveting detail on the firm’s accounting practices. That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis.

... Only further investigation will determine whether the individuals involved can be indicted and convicted of criminal wrongdoing.

... Lehman structured its repo agreements so that the collateral was
worth 105 percent of the cash it received – hence, the name “Repo 105.”
As explained by the New York Times' DealBook, “That meant that for a
few days – and by the fourth quarter of 2007 that meant end-of-quarter –
Lehman could shuffle off tens of billions of dollars in assets to
appear more financially healthy than it really was.” [Hey, I can
name several banks that are doing that right now. One might even rhyme
with the name Max
]

... Even worse, Lehman’s management trumpeted how the firm was
decreasing its leverage so that investors would not flee from the firm.
But inside Lehman, according to the report, someone described the Repo
105 transactions as “window dressing,” a nice way of saying they were
designed to mislead the public.

... Mr. President, the SEC and Justice Department should pursue a
thorough investigation, both civil and criminal, to identify every last
person who had knowledge that Lehman was misleading the public about its
troubled balance sheet – and that means everyone from the Lehman
executives, to its board of directors, to its accounting firm, Ernst
& Young. Moreover, if the foreign bank counterparties who purchased
the now infamous "Repo 105s" were complicit in the scheme, they should
be held accountable as well.

... Mr. President, it is high time that we return the rule of law to
Wall Street, which has been seriously eroded by the deregulatory mindset
that captured our regulatory agencies over the past 30 years [Preach
on my brother from another mother...
]

The allure of deregulation, instead, led to the biggest financial
crisis since 1929. And now we’re learning, not surprisingly, that fraud
and lawlessness were key ingredients in the collapse as well. Since
the fall of 2008, Congress, the Federal Reserve and the American
taxpayer have had to step into the breach – at a direct cost of more
than $2.5 trillion – because, as so many experts have said: "We had to
save the system."

But what exactly did we save? [Don't get me started...]

First, a system of overwhelming and concentrated financial power that
has become dangerous. It caused the crisis of 2008-2009 and threatens to
cause another major crisis if we do not enact fundamental reforms.
Only six U.S. banks control assets equal to 63 percent of the nation’s
gross domestic product, while oversight is splintered among various
regulators who are often overmatched in assessing weaknesses at these
firms.

... a system in which the rule of law has broken yet again. Big banks
can get away with extraordinarily bad behavior – conduct that would not
be tolerated in the rest of society.

Mr. President, what lessons should we take from the bankruptcy
examiner’s report on Lehman, and from other recent examples of
misleading conduct on Wall Street? I see three.

First, we must undo the damage done by decades of deregulation. That
damage includes financial institutions that are “too big to manage and
too big to regulate” (as former FDIC Chairman Bill Isaac has called
them), a “wild west” attitude on Wall Street, and colossal failures by
accountants and lawyers who misunderstand or disregard their role as
gatekeepers. The rule of law depends in part on manageably-sized
institutions, participants interested in following the law, and
gatekeepers motivated by more than a paycheck from their clients. [Amen!!!!!!!
Ladies and gentlemen, Reggie brings you
:

Any
objective review shows that the big banks are simply too big for the
safety of this country

Why
Doesn't the Media Take a Truly Independent, Unbiased Look at the Big
Banks in the US?

As
the markets climb on top of one big, incestuous pool of concentrated
risk...

Why
hasn't anybody questioned those rosy stress test results now that the
facts have played out?

An
Independent Look into JP Morgan

When considering the staggering level of derivatives employed by JPM,
it is frightening to even consider the fact thatthe quality of JPM's
derivative exposure is even worse than Bear Stearns and Lehman‘s
derivative portfolio just prior to their fall
.Total net derivative exposure
rated below BBB and below for JP Morgan currently stands at 35.4% while
the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for
Lehman (May 2008). We all know what happened to Bear Stearns and Lehman
Brothers, don't we??? I warned all about Bear Stearns (Is
this the Breaking of the Bear?
: On Sunday, 27 January 2008, three
months before their collapse) and Lehman ("Is
Lehman really a lemming in disguise?
": On February 20th, 2008,
months before their collapse) by taking a close, unbiased look at their
balance sheet. Don't let anyone tell you that these companies' collapse
couldn't have been seen coming. I saw them coming and I clearly
articulated it in BoomBustBlog j
ust as I
am warning YOU, NOW!
And now, back to the esteemed Senator's
speech...]

Second, we must concentrate law enforcement and regulatory resources on
restoring the rule of law to Wall Street. We must treat financial
crimes with the same gravity as other crimes, because the price of
inaction and a failure to deter future misconduct is enormous.

Third, we must help regulators and other gatekeepers not only by
demanding transparency but also by providing clear, enforceable “rules
of the road” wherever possible. That includes studying conduct that may
not be illegal now, but that we should nonetheless consider banning or
curtailing because it provides too ready a cover for financial
wrongdoing. [My dear Senator, might I suggest allowing accountants to
return to making accounting rules rather than lobbyists and politicians.
A clear and quick reinstatement of the mark to market rules (and
insuring that they are aptly enforced) will go a very long way with
practically no legislation. Please, please see "About
the Politically Malleable FASB, Paid for Politicians, and Mark to Myth
Accounting Rules
". Of course, a practical action such as this may
very well force the market to return to being valued off of fundamentals
versus rumors, innuendo, gossip and 5 SPARC servers arguing with each
other through high frequency trading algorithms...

If the engineered bear market rally is running off of the FASB
generated lies, then we certainly do have another crash coming, don't
we? ]

The bottom line is that we need financial regulatory reform that is
tough, far-reaching, and untainted by discredited claims about the
efficacy of self-regulation...

We wanted to make certain that the Department of Justice and other law
enforcement authorities had the resources necessary to investigate and
prosecute precisely the sort of fraudulent behavior allegedly engaged in
by Lehman Brothers...

Many have said we should not seek to "punish" anyone, as all of Wall
Street was in a delirium of profit-making and almost no one foresaw the
sub-prime crisis caused by the dramatic decline in housing values. [HA!
I think the technical term for this statement is.....
BULLSHIT!!!

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

(a year before the CRE crash) It wasn't hard to see that commercial
real estate was ready to implode and that GGP was about to collapse
under its own weight. Why didn't our regulators see what I saw?

Yeah,
Countrywide is pretty bad, but it ain’t the only one at the subprime
party… Comparing Countrywide
Countrywide and Washington Mutual's
collapse were visible AT LEAST a year in advance!

As
I see it, 32 commercial banks and thrifts may see the feces hit the fan
blades
(a year before they started to fall) It wasn't hard to see
that nearly all of these 32 banks would be facing the threat of
insolvency. Why didn't our regulators see what I saw?

The
Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk -
Beware what lies beneath!
Warned a year ahead. 'Nuff said...

Here's
Another "I Told 'ya So" for the Muni Buyers
: Two years ago I warned
that our municipalities will probably start defautling

Is
this the Breaking of the Bear?
: On Sunday, 27 January 2008, three
months before their collapse

"Is
Lehman really a lemming in disguise?"
: On February 20th, 2008,
months before their collapse

 

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

and Ambac
is Effectively Insolvent & Will See More than $8 Billion of Losses
with Just a $2.26 Billion in Equity 11/29/2007
I made it clear that
not only are these companies insolvent with business models based upon
near fraudulent relationships with ratings agencies, but the entire MBS
business will come crashing down - 3 years ago.]

This is about addressing the continuum of behavior that took place –
some of it fraudulent and illegal -- and in the process addressing what
Wall Street and the legal and regulatory system underlying its behavior
have become.

As part of that effort, we must ensure that the legal system tackles
financial crimes with the same gravity as other crimes. When crimes
happened in the past (as in the case of Enron, when aided and abetted
by, among others, Merrill Lynch, and not prevented by the supposed
gatekeepers at Arthur Andersen), there were criminal convictions. If
individuals and entities broke the law in the lead up to the 2008
financial crisis (such as at Lehman Brothers, which allegedly deceived
everyone, including the New York Fed and the SEC), there should be civil
and criminal cases that hold them accountable...

If we uncover bad behavior that was nonetheless lawful, or that we
cannot prove to be unlawful (as may be exemplified by the recent
reports of actions by Goldman Sachs with respect to the debt of Greece
),
then we should review our legal rules in the US and perhaps change them
so that certain misleading behavior cannot go unpunished again. [Oh,
I will assist you on expounding on Goldman a few paragraphs below. I
hope you are reading this blog!
] This will not be easy. As the
Wall Street Journal’s “Heard on the Street” noted last week, “Give Wall
Street a rule and it will find a loophole.”

Systemic issues in Uncovering and Prosecuting Fraud This confirms what I
heard On December 9 of last year, when I convened an oversight hearing
on FERA. As that hearing made clear, unraveling sophisticated financial
fraud is an enormously complicated and resource-intensive undertaking,
because of the nature of both the conduct and the perpetrators. [My
Senatorial Friend, you should more time in the blogosphere. Not only
would you have realized that it was quite possible to see the crash of
2008 coming, but it is also quite possible to see the crash of 2010
coming as well as unraveling financial fraud. Our system is wrought with
regulatory capture. If someone is paid (either directly or subvertly)
not to see something, they probably will not see it - reference How
Regulatory Capture Turns Doo Doo Deadly
and Lehman
Brothers and Its Regulators Deal the Ultimate Blow to Mark to Market
Opponents.
]

Rob Khuzami, head of the SEC’s enforcement division, put it this way
during the hearing:

“White-collar area cases, I think, are distinguishable from terrorism
or drug crimes, for the primary reason that, often, people are plotting
their defense at the same time they're committing their crime. They are
smart people who understand that they are crossing the line, and so they
are papering the record or having veiled or coded conversations that
make it difficult to establish a wrongdoing.”

In other words, Wall Street criminals not only possess enormous
resources but also are sophisticated enough to cover their tracks as
they go along, often with the help, perhaps unwitting, of their lawyers
and accountants. [Listen, a thief is a thief. Some are smart, some
are not. Wall Street comes nowhere near having a monopoly on craftiness
nor intelligence. I have given many instances in the paragrahp above
where I have caught companies in many a shenanigan and anticipated in
illustrious detail the biggest crashes of this lifetime that no one
apparently saw coming. I did this with a small cadre of analysts and an
unbiased eye. It had nothing to do with my being smart! Imagine if I was
paid to do this and more without outside influences and biases!
]

Is Lehman Brothers an Isolated Example?

Mr. President, I’m concerned that the revelations about Lehman Brothers
are just the tip of the iceberg. We have no reason to believe that the
conduct detailed last week is somehow isolated or unique. Indeed, this
sort of behavior is hardly novel. Enron engaged in similar deceit with
some of its assets. And while we don’t have the benefit of an
examiner’s report for other firms with a business model like Lehman’s,
law enforcement authorities should be well on their way in conducting
investigations of whether others used similar “accounting gimmicks” to
hide dangerous risk from investors and the public. [I don't know
about the government, but I definitely have my guys digging deep holes.
]

The Case of Greece

At the same time, there are reports that raise questions about whether
Goldman Sachs and other firms may have failed to disclose material
information about swaps with Greece that allowed the country to
effectively mask the full extent of its debt just as it was joining the
European Monetary Union (EMU). We simply do not know whether fraud was
involved, but these actions have kicked off a continent-wide
controversy, with ramifications for U.S. investors as well.

In Greece, the main transactions in question were called cross-currency
swaps that exchange cash flows denominated in one currency for cash
flows denominated in another. In Greece’s case, these swaps were priced
“off-market,” meaning that they didn’t use prevailing market exchange
rates. Instead, these highly unorthodox transactions provided Greece
with a large upfront payment (and an apparent reduction in debt), which
they then paid off through periodic interest payments and finally a
large “balloon” payment at the contract’s maturity. In other words,
Goldman Sachs allegedly provided Greece with a loan by another name.

The story, however, does not end there. Following these transactions,
Goldman Sachs and other investment banks underwrote billions of Euros in
bonds for Greece. The questions being raised include whether some of
these bond offering documents disclosed the true nature of these swaps
to investors, and, if not, whether the failure to do so was material.

These bonds were issued under Greek law, and there is nothing
necessarily illegal about not disclosing this information to bond
investors in Europe. At least some of these bonds, however, were likely
sold to American investors, so they may therefore still be subject to
applicable U.S. securities law. While “qualified institutional buyers”
(QIBs) in the U.S. are able to purchase bonds (like the ones issued by
Greece) and other securities not registered with the SEC under
Securities Act of 1933, the sale of these bonds would still be governed
by other requirements of U.S. law. Specifically, they presumably would
be subject to the prohibition against the sale of securities to U.S.
investors while deliberately withholding material adverse information.

The point may be not so much what happened in Greece, but yet again the
broader point that financial transactions must be transparent to the
investing public and verified as such by outside auditors. AIG fell in
large part due to its credit default swap exposure, but no one knew
until it was too late how much risk AIG had taken upon itself. Why do
some on Wall Street resist transparency so? Lehman shows the answer:
everyone will flee a listing ship, so the less investors know, the
better off are the firms which find themselves in a downward spiral. At
least until the final reckoning.

...

As I said more than a year ago: "At the end of the day, this is a test
of whether we have one justice system in this country or two. If we
don’t treat a Wall Street firm that defrauded investors of millions of
dollars the same way we treat someone who stole 500 dollars from a cash
register, then how can we expect our citizens to have faith in the rule
of law? For our economy to work for all Americans, investors must have
confidence in the honest and open functioning of our financial markets.
Our markets can only flourish when Americans again trust that they are
fair, transparent, and accountable to the laws."

The American people deserve no less.

Whoa! That was some speech coming out of a the senate. You see, it is
admirable that Senator Kaufman, and even Senator Dodd are trying to
reign in entities that are distorting the financial landscape, but I
feel they could accomplish so much more if they really knew how to pick
apart these companies to see what is beneath the hood, how it works, and
how it has been applied to transactions in the past.

In the post, "Smoking
Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer
Beware!
" I illustrated the swap deal that appears to be at the
center of one of Senator Kaufman's issues:

According to people familiar with the matter interviewed by China
Securities Journal, Goldman Sachs Group Inc. did as many as 12
swaps for Greece from 1998 to 2001, while Credit Suisse was also
involved with Athens, crafting a currency swap for Greece in the same
time frame.

Under its "off-market" swap in 2001, Goldman agreed to convert yen and
dollars into euros at an artificially favorable rate in the future. This
helped Greece to use that "low favorable rate" when it recorded its
debt in the European accounts-pushing down the country's reported debt
load.

Moreover,in exchange for the good deal on rates, Greece
had to pay Goldman
(the
amount wasn't revealed).And since the payment would count
against Greece's deficit, Goldman and Greece came up with another
twist: Goldman effectively loaned Greece the money for the payment, and
Greece repaid that loan over time
.And the two sides structured the loan as
another kind of swap. So, the deal didn't add to Greece's debt under EU
rules
. Consequently, Greece's total debt as a percentage of GDP fell
from 105.3% to 103.7%, and its 2001 deficit was reduced by a tenth of a
percentage point in GDP terms, according to people close to Goldman
.

Another action that smacks of Hellenic manipulation, at least to the
staff of BoomBustBlog: for years it apparently and simply omitted large
portions of its military-equipment spending from its deficit
calculations. Though, European regulators eventually prevailed on Greece
to count everything and as a result, in 2004, there was a massive
revision of Greek deficit figures from 2000 (a budget deficit of 2.0% of
GDP in 2000 to beyond the 3% deficit limit in 2004), by then Greece had
already gained entrance to the euro. As in my trying to prepare for the
coming sovereign debt crisis, timing is everything, isn't it???

This is far, far from the only instance where it appears Goldman may
have not given full disclosure to its prospective and actual clients.
Before we get to a few other anecdotal instances, let's review exactly
how profitable this company really is if we were to take an objective,
risk-adjusted view. After all, the apparent shenanigans that are
mentioned throughout this post and by Senator Kaufman are quite risky,
aren't they?

Goldman is a very, very well run company. It is loved by some, reviled
by others, but in the end it is respected for something that it truly
does not deserve. That something is the ability to make an above average
return on risk adjusted capital. Goldman takes gobs of risk! From an
economic income perspective, it is mediocre to average at best. See " For
Those Who Chose Not To Heed My Warning About Buying Products From Name
Brand Wall Street Banks, "

GS return on equity has declined substantially due to deleverage and
is only marginally higher than its current cost of capital. With ROE
down to c12% from c20% during pre-crisis levels, there is no way a stock
with high beta as GS could justify adequate returns to cover the
inherent risk. For GS to trade back at 200 it has to increase its
leverage back to pre-crisis levels to assume ROE of 20%. And for that GS
has to either increase its leverage back to 25x. With curbs on banks
leverage this seems highly unlikely. Without any increase in leverage
and ROE, the stock would only marginally cover returns to shareholders
given that ROE is c12%. Even based on consensus estimates the stock
should trade at about where it is trading right now, leaving no upside
potential. Using BoomBustBlog estimates, the valuation drops
considerably since we take into consideration a decrease in trading
revenue or an increase in the cost of funding in combination with a
limitation of leverage due to the impending global regulation coming
down the pike. Using your method, our valuation would drop from where it
is to an even lower point.

Second, it still has a bunch of trash on its balance sheet, seeReggie
Middleton vs Goldman Sachs, Round 2.

If you look at the period of the most recent credit bubble,
Goldman did everything that the other failed and bailed out banks did:
leveraged up on trash assets, invested in and sold the worthless junk,
and ran to the government for aid and bailouts:

So, what is GS if you strip it of its government protected, name
branded hedge fund status. Well, my subscribers already know. Let' take a
peak into one of their subscription documents Goldman Sachs Stress Test
Professional 2009-04-20 10:06:45 4.04 Mb - 131 pages). I believe
many with short term memory actually forgot what got this bank into
trouble in the first place, and exactly how it created the perception
that it got out of trouble. The (Off) Balance Sheet!!!

Contrary to popular belief, it does not appear that Goldman is a
superior risk manager as compared to the rest of the Street. They may
the same mistakes and had to accept the same bailouts. They are
apparently well connected though, because they have one of the riskiest
balance sheet compositions around yet managed to get themselves insured
and protected by the FDIC like a real bank. This bank's portfolio looked
quite scary at the height of the bubble.

As a matter of fact, it looks just as scary today as it does at the
height of the bubble, but since very few people read balance sheets, no
one really notices.

 

You know what most people don't realize is that it looks quite scary
now as well.

Senator Kaufman justifiably takes issue with Goldman selling European
sovereign debt securities without full disclosure. If the honorable
Senator were to dig a little deeper, he would find that there may be a
lot more to that theory than he initially believed...

 

 

In April of 2006, a Goldman Sachs formed "Goldman Sachs Alternative
Mortgage Products", an entity that pushed residential mortgage backed
securities to its victims clients
through GSAMP Trust 2006-S3 in a similar fashion to the sales and
marketing of the CRE CMBS that is being pushed to its victimsclients as described
in the links above. The residential real estate market faced very dire
fundamental and macro headwinds back then, just as the commercial real
estate market does now. I don't think that is the end of the
similarities, either.

Less then a year and a half after this particular issue was floated, a
sixth of the borrowers defaulted on the loans behind this product,
according to CNN/Fortune,
where the graphic below was sourced from.

 

 

Here's an excerpt from the article of October 2007 (less than a year after the issue
was sold to Goldman clients, clients who probably didn't know that
Goldman was short RMBS even as Goldman peddled this bonus bulging trash
to them)
:

 

By February
2007, Moody's and S&P began downgrading the issue. Both agencies
dropped the top-rated tranches all the way to BBB from their original
AAA, depressing the securities' market price substantially.

In March, less
than a year after the issue was sold, GSAMP began defaulting on its
obligations. By the end of September, 18% of the loans had defaulted,
according to Deutsche Bank.

As a result,
the X tranche, both B tranches, and the four bottom M tranches have been
wiped out, and M-3 is being chewed up like a frame house with termites.
At this point, there's no way to know whether any of the A tranches
will ultimately be impaired...

,,, Goldman said
it made money in the third quarter by shorting an index of
mortgage-backed securities. That prompted
Fortune to ask
the firm to explain to us how it had managed to come out ahead while so
many of its mortgage-backed customers were getting stomped.

Just one month later from :

 

 

Feb. 23 (Bloomberg)

Representative Darrell
Issa, the ranking Republican on the House Committee on Oversight
and Government Reform, placed into the hearing record a five-page
document itemizing the mortgage securities on which banks such asGoldman Sachs Group Inc.and Societe Generale SA had bought
$62.1 billion in credit-default swaps from AIG...

The public can now see for the first time how poorly the securities
performed,with losses exceeding 75 percent of their
notional value in some cases.
Compounding
this, the document and Bloomberg data demonstrate thatthe
banks that bought the swaps from AIG are mostly the same firms that
underwrote the CDOs in the first place.

The banks should
have to explain how they managed to buy protection from AIG primarily on
securities that fell so sharply in value
, says Daniel
Calacci, a former swaps trader and marketer who’s now a
structured-finance consultant in Warren, New Jersey. In some cases,banks also owned mortgage
lenders, and they should be challenged to explain whether they gained
any insider knowledge about the quality of the loans bundled into the
CDOs,
he says. [Let's
not play games here. The banks knew what trash was hidden where!]

‘Too Uncanny’

“It’s almost too uncanny,” Calacci says. “If these banks had insight into the
underlying loans because they had relationships with banks, originators
or servicers, that’s at the least unethical.
”[At the very least. I think it's
called ILLEGAL!
]

The identification of securities in the document, known as Schedule A,
and data compiled by Bloomberg show thatGoldman Sachs underwrote $17.2 billion of the $62.1 billion in
CDOs that AIG insured -- more than any other investment bank.
Merrill Lynch & Co., now part
of Bank of America Corp., created $13.2 billion of the CDOs, and
Deutsche Bank AG underwrote $9.5 billion.

These tallies
suggest a possible reason why the New York Fed kept so much under wraps
,
Professor James
Cox of Duke University School of Law
says: “They may
have been trying to shield Goldman
-- for Goldman’s sake or out of
macro concerns that another investment bank would be at risk.”

 

 

This is all gathered from anecdotal, occasional blogging. If someone
such as myself were to really dig in and search for
smoking guns, I am confident smoldering canons will be revealed. I
think the electorate should stand be behind Senator Kaufman for his
willingness to clean up a system which has become too one--sided, too
political, and (darest I say it), too corrupt.

 

More of Reggie on Goldman Sachs

Reggie
Middleton vs Goldman Sachs, Round 2

Reggie
Middleton Personally Contragulates Goldman, but Questions How Much More
Can Be Pulled Off

Get
Your Federally Insured Hedge Fund Here, Twice the Price Sale Going on
Now!

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

Reggie
Middleton's Goldman Sach's Stress Test: Breaking Ranks with the Crowd
Once Again!

Who
is the Newest Riskiest Bank on the Street?

More remium
Stuff!

 

Reggie
Middleton on Goldman Sachs' fourth quarter, 2008 results

Goldman Sachs' Bank Holding Company
Fundamental Valuation and Forensic Analysis - Retail 2008-10-20
15:45:05 348.99
Kb

Goldman Sachs' Bank Holding Company
Fundamental Valuation and Forensic Analysis - Professional 2008-12-18
10:12:37 267.49
Kb

Free research
and opinion

To begin with , Goldman Sachs produces more accounting revenue and accounting profits than its peers. This is because Goldman benefits from virtual monopoly pricing and advantages in several markets. Despite this advantage, when one factors in economic RISK and the cost of capital, Goldman doesn't fare nearly as well as the sell side makes it seem. Of course, the sell side rarely attempts to quantify risk, which is cool until reality rears its (sometimes ugly) head. Before we get to risk adjust returns, let's look at the simple accounting numbers and attempt to throw some logic on them...

Above, you see that GS has enjoyed a significant premium over its peers in terms of book valuation. This premium has actually increased over the past year. Let me be the one to remind you that no US company has every survived a criminal judgment, none. Arther Anderson was driven into bankruptcy from charges stemming from the Enron collapse, and that is despite the fact that the Supreme Court overturned the guilty verdict! Assuming, for the benefit of the doubt, GS can somehow set precedence, or more realistically, criminal charges are not filed, we still have to contend with:

  1. the SEC lawsuit
  2. the increased regulation, in particular the Volcker rule and derivatives oversight
  3. follow on litigation, which is virtually guaranteed, and virtually guaranteed to be extremely expensive, time consuming, and distracting from the core businesses.
  4. a general decline in business since we are coming off of a credit and risky asset boom and going into a sovereign debt crisis that will make FICC much less predictable (seeThe Next Step in the Bank Implosion Cycle??? for a more on how this could end with the Pan-European Sovereign Debt Crisis drama unfolding).

Taking all of this into consideration, you tell me... Does Goldman really deserve to be trading at such a premium considering the myriad risks it is currently exposed to PLUS the murky business and regulatory environment? They are also losing talent on the sales side, and at the MD level to boot. Today's market is starting to see things the Reggie Middleton way.

Now, let's factor in some more reality. No matter what your broker says about accounting earnings and revenues, they don't come free. They all have a cost of capital attached to them. Let's reference an excerpt from When the Patina Fades… The Rise and Fall of Goldman Sachs???

GS return on equity has declined substantially due to deleverage and is only marginally higher than its current cost of capital. With ROE down to c12% from c20% during pre-crisis levels, there is no way a stock with high beta as GS could justify adequate returns to cover the inherent risk. For GS to trade back at 200 it has to increase its leverage back to pre-crisis levels to assume ROE of 20%. And for that GS has to either increase its leverage back to 25x. With curbs on banks leverage this seems highly unlikely. Without any increase in leverage and ROE, the stock would only marginally cover returns to shareholders given that ROE is c12%. Even based on consensus estimates the stock should trade at about where it is trading right now, leaving no upside potential. Using BoomBustBlog estimates, the valuation drops considerably since we take into consideration a decrease in trading revenue or an increase in the cost of funding in combination with a limitation of leverage due to the impending global regulation coming down the pike.

Remember, practically everybody poo-poohed my research and opinion in 2008 when I said Goldman was drastically overvalued - Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis Those 600% to 1000% gains on the put options proved otherwise. Speaking of which, those July 150 puts... Can you smell what the forensic analysis is cookin'???

For those who haven't read my review of Goldman's latest quarter performance, please do:A Realistic View of Goldman Sachs and Their Latest Quarterly Results

More of Reggie on Goldman Sachs

Reggie Middleton vs Goldman Sachs, Round 2

Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off

Get Your Federally Insured Hedge Fund Here, Twice the Price Sale Going on Now!

 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

Reggie Middleton’s Goldman Sach’s Stress Test: Breaking Ranks with the Crowd Once Again!

Who is the Newest Riskiest Bank on the Street?

More premium Stuff!

 

Reggie Middleton on Goldman Sachs’ fourth quarter, 2008 results

Goldman Sachs – Buffet’s strategic investment and public offering 2008-09-26 02:29:15 895.36 Kb

Goldman Sachs’ Bank Holding Company Fundamental Valuation and Forensic Analysis – Professional 2008-12-18 10:12:37 267.49 Kb

Goldman Sachs’ Bank Holding Company Fundamental Valuation and Forensic Analysis – Retail 2008-10-20 15:45:05 348.99 Kb

 

Goldman Sachs Valuation Model updated for PPIP – Retail 2009-04-04 19:50:51 388.04 Kb

Goldman Sachs’ Bank Holding Company Fundamental Valuation and Forensic Analysis – Professional 2008-12-18 10:12:37 267.49 Kb

The Creatively Destructive Pace of Technology Innovation and the Paradigm Shift known as the Mobile Computing Wars!

More on the Creatively Destructive Pace of Technology Innovation and the Paradigm Shift known as the Mobile Computing Wars!

  1. There Is Another Paradigm Shift Coming in Technology and Media: Apple, Microsoft and Google Know its Winner Takes All
  2. The Mobile Computing and Content Wars: Part 2, the Google Response to the Paradigm Shift
  3. An Introduction to How Apple Apple Will Compete With the Google/Android Onslaught
  4. Don’t Count Microsoft Out of the Ultra-Mobile Computing Wars Just Yet
  5. This article should drive the point home: An iPhone 4 Recall Will Hurt Apple More By Opening Additional Opportunity for Android Devices Than Increased Expenses
  6. A First in the Mainstream Media: Apple’s Flagship Product Loses In a Comparison Review to HTC’s Google-Powered Phone
  7. After Getting a Glimpse of the New Windows Phone 7 Functionality, RIMM is Looking More Like a Short Play
  8. RIM Smart Phone Market Share, RIP?
  9. Android is gaining preference as the long-term choice of application developers
  10. A Glimpse of the BoomBustBlog Internal Discussion Concerning the Fate of Apple
  11. Math and the Pace of Smart Phone Innovation May Take a Byte Out of Apple’s (Short-lived?) Dominance
  12. Apple on the Margin
  13. RIM Smart Phone Market Share, RIP?
  14. Motorola, the Company That INVENTED the Cellphone is Trying to Uninvent the iPad With Android
  15. Android Now Outselling iOS? Explaining the Game of Chess That Google Plays in the Smart Phone Space
  16. There Goes Those Fancy eBook Aspirations from Apple, Barnes and Noble, and Amazon: 100,000’s of FREE eBooks from the Public Library
  17. How Google is Looking to Cut Apple’s Margin and How the Sell Side of Wall Street Will Enable This Without Sheeple Investor’s Having a Clue
  18. Empirical Evidence of Android Eating Apple!
  19. More of the Android Onslaught: Increasing Handset Revenues and Growth
  20. Many More Black Eyes for the Blackberry? A Complete Forensic Analysis of Research in Motion
  21. The BoomBustBlog Multivariate Research in Motion Valuation Model: Ready for Download

From CNBC :

NEW
YORK (Reuters) - Shares of Lehman Brothers fell by nearly 10 percent in
early New York trading on Thursday on rumors that the fourth largest
U.S. investment bank could see a run on the bank similar to what
happened to Bear Stearns, traders said.

Declines
in Lehman's shares on Thursday are "all being tied to fears of Bear
Stearns," said Robert Bolton, head trader for Mendon Capital Advisors
in Rochester, New York. "Does another broker dealer go the route of
Bear Stearns with regard to their solvency and the like."

A Lehman spokeswoman called the rumors "totally unfounded," which contributed to the stock taking back much of its losses. Hey, isn't that what Bear Stearns said right before they were going to declare bankruptcy? Do you remember the "Short me, Please!" phrase?

Kerrie
Cohen, a spokeswoman for Lehman Brothers, said, "There are a lot of
rumors in the marketplace that are totally unfounded. We are suspicious
that the rumors are being promulgated by short sellers of our stock
that have an economic self interest." Hmmm... Is that your viewpoint when positive news about your stock is circulated and your stock rises, like last week? I suspect that rumors were being promulgated by long buyers of your stock that had an economic self interest! Let's not cast aspersions, since that can easily cut both ways. As a short seller of your stock, I am a bit sensitive.

At midday, Lehman shares were down 4.28 percent at $40.67 on the New York Stock Exchange, after falling as low at $38.36.

The
U.K.'s Times reported on March 19 that the U.S. Securities and Exchange
Commission (SEC) was probing whether hedge funds and other market
players deliberately circulated false rumors about Lehman Brothers to
push the company's shares lower. Which is cool, as long as they extend the investigation back to last week when the stock popped as well, looking for pump and dumpers. The macro and micro environment for these companies are extremely negative, performance and fundamentals are quite negative, and the outlook for the medium term looks bleak, with the threat of regulation for the long term. It makes much more sense for the stock to move down, rather than up. It bothers me when the government and the media (ala CNBC, et. al.) condone the pump and dump, but when valid concerns about fundamentals and macro trends arise there is all of a sudden a mass conspiracy.

Investors
have been skittish about investment banking shares since the middle of
the month when Bear Stearns Cos Inc experienced a run on the bank amid
fears that its mortgage exposure could leave it insolvent. Schwartz's statement right before his bank's collapse would be enough for anyone in their right minds to be concerned when Lehman decries the Short me, Please! phrase.

Other
traders, who declined to be identified, echoed Bolton's assessment for
the reason behind the drop in Lehman's shares. In addition, large
bearish bets on Lehman in options markets contributed to selling
pressure, some traders said. I'll have to admit that my position is not as large as it should be yet. It is larger than it was, but it hard to build a truly worthwhile position with the puts as expensive as they are, excessive IV.

Lou Brien, a
strategist with DRW Trading Group in Chicago, said there had been a
rumor on Thursday that Lehman was close to making an announcement,
which contributed to the shares selling off, but the announcement
proved to be about the bank hiring a new co-head of global
institutional distribution, after which shares recovered.

Lehman
Brothers a decade ago derived an outsized proportion of its earnings
from the U.S. bond market and has long been an active player in
mortgages, leading some investors to argue the company could be
devastated by the credit crisis. But Lehman's business is much more
diversified than it was in the 1990s, and the company has not posted
any net losses during the credit crunch.The mere fact that they are so susceptible to risk rumors means that they are a risky bank. This is common sense. Who wants to rely on them as a countery party when they have to make an announcement every week to defend themselves against said "promulgators" as their share price drops 10%, 20% 40%, 50% and then pops up for a 20% run to fall back down 12 to 15% again - in just two weeks. Lehman's stock currently sports 195% volatility. That's more than on the options of many hot trading and gossip stocks like the homebuilders. Beta, risk, volatility, deviation from expected return, whatever moniker you want to slap on it, the shares of this company have grown quite risky, reflecting the risk premium the market has slapped on their business. Founded or not, it is there. Is it even worth the risk dealing with them? Who want's to be the huckleberry to find out?

Since
Bear was forced to announce plans to sell itself to JPMorgan Chase
& Co on March 16, the Federal Reserve has allowed investment banks
to borrow directly from the central bank, in a move designed to shore
up the financial system.

In an e-mailed
statement on March 17, Lehman Chief Executive Dick Fuld said the Fed's
creation of a liquidity facility for primary dealers "from my
perspective, takes the liquidity issue for the entire industry off the
table." If things keep going the way they are, Lehman will be the first to put Mr. Fuld's theory to the test.

Lehman said on March 18 that its
holding company has $34 billion of assets it could easily sell, and
another $64 billion of assets it could borrow against. Regulated
subsidiaries have another $99 billion of assets it could borrow against. Hmmm... "easily sell". That's the problem with liquidity. When you have liquid instruments, liquidity is always there - until there is a dearth of liquidity and you really need to sell them.

Japan is trading down, allegedly due in part to Lehman liquidity concerns. There would be much less gossip and innuendo if Lehman didn't hit the discount window the second it was available. See Wall Street Firms Borrowing Heavily From the Fed

Big Wall Street investment
companies are taking advantage of the Federal Reserve's unprecedented offer to
secure emergency loans, the central bank reported Thursday.

Those firms averaged $32.9 billion
in daily borrowing over the past week from the new lending facility, compared
with $13.4 billion the previous week. The program, which began last Monday, is
part of the Fed's effort to aid the financial system.On Wednesday alone, lending
reached $37 billion.

On a seperate, but related note, I may be bringing the blog analysis over to Europe. Lehman forcasts a 35% chance of recession in the UK and a drop in the official rates from the BOE. The UK and eurozone banks are doing as bad as the US banks, if not worse. The pound is due for a pounding as well, both against the dollar and the euro. So, if the financial stocks rally against the fundamentals ala the US financials, I will start my shorts over there as well. I will be doubly as speculative, but the potenial return is worth the risk in my eyes.

 

I Suggest Those That Dislike Hearing "I Told You So" Divest from Western and Southern European Debt, It'll Get Worse Before It Get's Better!

So, S&P finally gets around to

Ireland's financial headache worsened on Wednesday after Standard & Poor's cut its credit rating in a move criticized by the country's debt management agency.

...

The premium investors demand to hold Ireland's 10-year bonds over German bunds has been steadily widening in the past few weeks and remained elevated at 327 basis points on Wednesday.

The spread finished at 330 bps on Tuesday, its highest level since the Greek financial crisis broke in May.

Brenda Kelly, an analyst at CMC Markets, said she expected Irish borrowing costs to climb on the back of S&P's move.

"I think we are going to have to an awful lot more in interest payments," she said.

Although Ireland has raised virtually all of the 20 billion euros of long-term debt targeted for 2010, S&P's move may make it more difficult for the country's banks to extend the maturity of their funding later this year and eventually wean themselves off a state guarantee on their debt.

...

S&P cut Ireland's long-term rating by one notch to 'AA-', the fourth highest investment grade, and assigned the country a negative outlook late on Tuesday saying the cost to the government of supporting the financial sector had increased significantly.

Rating agencies have been steadily hacking away at Ireland's credit rating and S&P's is now on a par with Fitch and one notch below Moody's, which cut its rating to Aa2 last month.

S&P said it expects Ireland will need to spend 90 billion euros to support its banking system, up from its prior estimate of 80 billion euros including capital used to improve the solvency of financial institutions and losses taken from loans the government acquired from banks.

Ireland's budget deficit ballooned to 14 percent of gross domestic product, the highest in Europe, last year due to the cost of propping up nationalized lender Anglo Irish ANGIB.UL and it could climb higher if Dublin injects an additional 10.05 billion euros into the bank...

I'm not going to say I told you so, but I did throw some pretty strong hints...

On April 29th, I was quite blatant in stating "Beware of the Potential Irish Ponzi Scheme!", urging my susbscribers to review thetask=doc_download&gid=308&Itemid=104" target="_blank" rel="noopener noreferrer"> Irish Bank Strategy Note and the alt="File Icon" border="0" /> Ireland public finances projections that I made available earlier that month. You see, unlike many of the pundits in Europe who state that Ireland has moved beyond the worst of its problems and is an example of how austerity should work, I believe that Ireland is in very, very big trouble and I outlined the reasoning behind such in my very first posts on the .

image009.png

At the very beginning of the year, I visually illustrated how bad off Ireland was, with considerably more that 6% of its GDP being mired in bank NPAs (non-performing assets). This number is quite conservative, for my research team only canvassed the larger banks in Ireland - you can rest assured that the smaller ones contain a similar (if not greater) proportion of NPAs to total assets. Add to this the fact that these banks are probably overstating assets and understating liabilities and you can probably throw another 150 basis points on top of the figures above and still be a tad bit conservative.

As a matter of fact, I went further into the topic in mid-April with Many Institutions Believe Ireland To Be A Model of Austerity Implementation But the Facts Beg to Differ! where I showed that Ireland is heavily leveraged into the problems of the PIIGS group faced. A picture (and/or graph is worth a thousand words! From the afore-linked post...

For the most part, Ireland has considerable embedded risk through both foreign claims on troubled countries (ex. PIIGS) and significant bank NPAs as a percent of its GDP.

ireland_claims_against_piigs.jpg

Below is an excerpt from our recent forensic Ireland analysis. Subsccribers, please download the most recent report Ireland public finances projections_040710:

A deteriorating external environment and a correction in the domestic housing market made 2009 a difficult year for the Irish economy. Ireland’s GDP growth registered a fall of 7.5% (the highest rate of decline since the country’s records have been compiled) with a fiscal deficit of 11.7% of the GDP for 2009.

I then followed up with a recap of my findings along with a snapshot of the social unrest that economic turmoil is bound to bring about in BoomBustBlog Irish Research Becomes Reality...

Banks protesters storm Irish parliament

Wednesday, 12 May 2010

 

Gardai Clash with protestors marching against government cutbacks outside the Gates of Leinster House in Dublin tonight

Have they read my report?

The title of my research really says it all (Many Institutions Believe Ireland To Be A Model of Austerity Implementation But the Facts Beg to Differ!), yet the pictures really do drive the point home.

So if Ireland is really that bad off, what's up with that tall stalk next to it in the bank NPA chart at the beginining of the post? Oh, those are the guys (and gals) who lent Ireland all of that money, and Ireland's issues are probably a significant portion of those NPAs you see towering over that of Ireland. Here's a look at their public finances (for subscribers only UK Public Finances March 2010). I am not picking on Ireland and the UK, for much of Europe suffers from similar anathema, reference Ovebanked, Underfunded, and Overly Optimistic: The New Face of Sovereign Europe, wherein I delve into this topic in detail.

It is not as if no one could see the Euro-bank issues coming. In January of 2009, I explained to readers that the real estate bust in Spain could not be avoided by the banks and there will be a time when the piper comes a callin' (see The Spanish Inquisition is About to Begin…, and then Spanish Banking Macro Discussion Note 2010-02-09 02:48:06 519.40 Kb).). This, of course, will be subsidized by the Spanish state, as subscribers can reference out study of the Spanish Government's Public Finances This didn't just start with Greece, although I Think It’s Confirmed, Greece Will Be the First Domino to Fall.

So what does it all mean?

Well, from my point of view, things rarely happen in a vacuum. Many European nations are over leveraged, overbanked, highly indebted, social powder kegs literally and economically sitting right next to each other. Lord forbid someone inadvertantly lights a match! Whether that match be of financial or economic origin (see Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter?) a very unpleasant domino effect will ensure. On that note, we revisit a BoomBustBlog proprietary stratagem... >Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!

The BoomBustBlog Sovereign Contagion Model

Nearly every MSM analysts roundup attempts to speculate on who may be next in the contagion. We believe we can provide the road map, and to date we have been quite accurate. Most analysis looks at gross claims between countries, which of course can be very illuminating, but also tends to leave out many salient points and important risks/exposures.

In order to derive more meaningful conclusions about the risk emanating from the cross border exposures, it is essential to closely scrutinize the geographical break down of the total exposure as well as the level of risk surrounding each component. We have therefore developed a Sovereign Contagion model which aims to quantify the amount of risk weighted foreign claims and contingent exposure for major developed countries including major European countries, the US, Japan and Asia major.

I.          Summary of the methodology

  • We have followed a bottom-up approach wherein we have first identified the countries/regions with high financial risk either owing to rising sovereign risk (ballooning government debt and fiscal deficit) or structural issues including remnants from the asset bubble collapse, declining GDP, rising unemployment, current account deficits, etc. For the purpose of our analysis, we have selected PIIGS, CEE, Middle East (UAE and Kuwait), China and closely related countries (Korea and Malaysia), the US and UK as the trigger points of the financial risk dissemination across the analysed developed countries.
  • In order to quantify the financial risk emanating in the selected regions (trigger points), we looked into the probability of the risk event happening due to three factors – a) government default b) private sector default c) social unrest. The probabilities for each factor were arrived on the basis of a number of variables determining the relative weakness of the country. The aggregate risk event probability for each country (trigger point) is the average of the risk event probability due to the three factors.
  • Foreign claims of the developed countries against the trigger point countries were taken as the relevant exposure. The exposures of each developed country were expressed as % of its respective GDP in order to build a relative scale for inter-country comparison.
  • The risk event probability of the trigger point countries was multiplied by the respective exposure of the developed countries to arrive at the total risk weighted exposure of each developed country.
  • Sovereign Contagion Model – Retail – contains introduction, methodology summary, and findings
  • Sovereign Contagion Model – Pro & Institutional – contains all of the above as well as a very detailed methodology map that explains what went into the model across dozens of countries.

My next post on the Pan-European Sovereign Debt Crisis will outlined the likely haircuts many investors will take on their European debt, using our proprietary in-house models. Interested parties can to our research materials.

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