A Conversation Between a CDS Trader and an Equity Strategist on the Coming European Implosion

Reggie Middleton's picture

This is a conversation I am having, via email, with a European
CDS trader that will be posting trade setups on BoomBustBlog based upon
my proprietary subscriber research. If you recall his background fromthe post As Requested By Our Constituency: Trade Setups and Examples Based on BoomBustBlog Research Designed to Capitalize on the Coming Eurocalypse:

... As I said I have traded mostly on the fixed income markets. What I mean by that is:

    • government bonds, euro-area, (or before it existed, peseta, lira, french franc,...), Sweden, Denmark, UK, US, Japan
    • short term interest futures in those markets  Euribor, Euro$ etc...
  • bond futures & options in those markets (tnotes, gilts, bunds, btps, jgb.
    • swaptions & caps & floors
  • inflation linked securities (US TIPS, Euro-CPI linked, etc.
    • G7 FX & options

In my best years, I managed more than 10
billion euros equivalent of bonds (and the corresponding derivatives). I
was doing 'proprietary' trading, in contrast with 'flow trading" - flow
trading is quoting to clients (pension funds, banks, insurers, hedge
funds...), and basically stuffing and frontrunning them - or in contrast
with exotic derivatives book where you stuff the client selling complex
products he doesn't understand and he cannot price by himself ;-)

On average, I made for the firm more than
30M euros a year. Return on asset not that big! Those were the years
where you had to be leveraged to make money due to low vol!  I was doing
mostly "relative value", picking pennies with "hedged" strategies. So
not a big trader like Brevan Howard and co, but I was not in the minor
league either. I must say im quite proud of having stuffed a few times
the likes of GS, JPM, DB and co.... I also ran the asset-liability
department of a French bank so I saw also the other side of the business
with all the accounting shenanigans, and I know how banking CEOs run
their company...

Here is part one of our email exchange (annotated to add relevant blog content)...

Dear Reggie

Thanks for sending all the material. Im quite surprised at the
quality of the material, which I would put largely on par or better than
industry produced stuff, and at the time your analysis were written,
you were certainly in the most aggressive camp, and the first to give
figures with full explanations.

However the material is dated and news abound, and all this crisis
has hit the tapes (as you predicted) and became mainstream, with daily
articles in the press and blogosphere.

I purposely sent him some relevant
material from last year to demsonstrate its prescience. Subscribers
should reference the mateial from recent quarters for updates, and fresh
Euro and US banking analysis is on tap for the upcoming weak.

I would tend to believe that from here, things are more double sided
than before, and risk-reward much less interesting than it used to be,
because there are now external factors like government intervention
which can kick the can, and screw valuations for a long time.

Anyway, its been game over already for many banks:

  1. Bank of Ireland's gone from 18 euros to 0.12 euros (= peanuts)!
    1. Clearly forcasted ahead of time in our File Icon Irish Bank Strategy Note which adequately warned before Irish banks dropped 85% in value. The File Icon Ireland public finances projections is also available to all paying members.
  2. Bigger banks like SocGen moved from 140+ to 38 hitting 17.5 in 2009.
  3. Credit Agricole 36 euros to 10 hitting 6 in 2009
  4. BNP went from 90 to 50 after hitting 20 in 2009
  5. French CAC40 peaked around 6000 in 2007 to 3850 today hitting 2500 in 2009.
  6. so SG and CAI have been divided by 3.5 basically while the CAC has lost 36% « only ». BNP is in line with the CAC.
    1. Clearly delineated ahead of time in our exposure reports File IconEuro Bank Soveregn Debt Exposure Final -Retail or File Icon Euro Bank Soveregn Debt Exposure Final – Pro & Institutional
  7. BAC used to be 46$, now 10$ after hitting less than 5$ in 2009 while JPM did much better 50$ to 40$ hitting less than 20
    1. [Reggie Comments] Yeah JPM is stubborn, but also digging a hole for itself. See An Independent Look into JP Morgan...
    2. image001.pngimage001.png

      Cute graphic above, eh? There is plenty of this in the public
      preview. When considering the staggering level of derivatives employed
      by JPM, it is frightening to even consider the fact that the
      quality of JPM's derivative exposure is even worse than Bear Stearns and
      Lehman‘s derivative portfolio just prior to their fall.
      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) 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. Both of these companies were
      rated investment grade at the time, just like "you know who". Now, I am
      not saying JPM is about to collapse, since it is one of the anointed
      ones chosen by the government and guaranteed not to fail - unlike Bear
      Stearns and Lehman Brothers, and it is (after all) investment grade
      rated. Who would you put your faith in, the big ratings agencies or your
      favorite blogger? Then again, if it acts like a duck, walks like a
      duck, and quacks like a duck, is it a chicken??? I'll leave the rest up
      for my readers to decide.

      This public preview is the culmination of several investigative posts
      that I have made that have led me to look more closely into the big
      money center banks. It all started with a hunch that JPM wasn't marking
      their WaMu portfolio acquisition accurately to market prices (see Is JP Morgan Taking Realistic Marks on its WaMu Portfolio Purchase? Doubtful!
      ), which would very well have rendered them insolvent - particularly if
      that was the practice for the balance of their portfolio as well (see Re: JP Morgan, when I say insolvent, I really mean insolvent).
      I then posted the following series, which eventually led to me finally
      breaking down and performing a full forensic analysis of JP Morgan,
      instead of piece-mealing it with anecdotal analysis.

      1. The Fed Believes Secrecy is in Our Best Interests. Here are Some of the Secrets
      2. Why Doesn't the Media Take a Truly Independent, Unbiased Look at the Big Banks in the US?
      3. As the markets climb on top of one big, incestuous pool of concentrated risk...
      4. Any objective review shows that the big banks are simply too big for the safety of this country
      5. Why hasn't anybody questioned those rosy stress test results now that the facts have played out?

      You can download the public preview here. If you find it to be of
      interest or insightful, feel free to distribute it (intact) as you wish.
      JPM Public Excerpt of Forensic Analysis Subscription JPM Public Excerpt of Forensic Analysis Subscription 2009-09-18 00:56:22 488.64 Kb. I discussed JPM on CNBC's Squawk on the Street - 10/19/2010

      I also illustrated the catch 22 that the European banks are in as the Keynote Speaker at the ING Annual
      Valuation Conference in Amsterdam last April. All should be aware that
      the US banks wrote most of the CDS on said European names.

Both US and European banking systems stand on the precipice: Re Click, Clack, Click: The Sound of Falling Dominoes Behind The Door of the Eurocalypse! and The Beginning of the End of the Beginning of the Gutting of the Big Banks Has Begun!

Even if the banking system is insolvent, it doesnt mean those stocks
are going to go immediately to 0.1 like Bank of Ireland, that’s the

If a major credit event hits (currently
brewing in Europe, US, Japan and China), insolvent bank equity will do
the same thing that the previous insolvent US bank equity did - even
with the Fed's added equity lines. Yes, I know the big white shoe
investment bank analysts never say this, but who has been more accurate
over time, them or Reggie? From Did Reggie Middleton, a Blogger at BoomBustBlog, Best Wall Streets Best of the Best?
we can find the result of the Fed's backstopping of Lehman's equity
during a liquidity run on an insolvent bank during a major credit event
and what the allegedly "respected" bank analyists had to say about it
versus BoomBustBlog opinion...

Reggie vs Goldman Sachs

Why didn't Wall Street read my post on Lehman being a yellow lying lemon? See "Is Lehman really a lemming in disguise?"
and realize that this post was made on February 20th, when Goldman
Sachs had a recommended price of about $55 while this blog warned that
Lehman may be done for. This very similar to when I warned about the
potential demise of Bear Stearns in January, when the rest of the Street
had a "buy" at about $130 per share. See Is this the Breaking of the Bear?. 7 We all know how both of these stories ended.

Please click the graph to enlarge to print quality size.


Interesting to note that the Texas Ratio in your note European Bank
Sovereign Debt from May2010 was in line with the relative performance of
the 3 French bank stocks.

Those who don't subscriber should reference The Anatomy of a Serial European Banking Collapse for a preview...

Whoa!!! A 63 Texas Ratio when
losses were half of what they are now????!!! As Americans, and TExans
from the S&L Crisis area know, a Texas Ration of 100% generally
means no more bank!




Where would said Texas Ratio madness come from? Why, exposure - of course!





Though probably other ratios would have worked as well at it is known
that Crédit Agricole or SG have bigger funding problems than BNP. BNP
also seemingly bought Fortis at what seems distressed prices so far
(they make regret it if/when Belgium goes ballistic but thats not for

The sector has clearly seen winners and losers, which means stock
picking (in retrospect) can produce a lot of alpha but I doubt the
sovereign Texas ratio is the only factor at play and that bets should be
placed on that only measure.

[Reggie Comment] We have a lot of bank analysis to pick apart opportunities. Texas ratios simply scratch the surface!

I think you will agree with me the sovereign exposure is the stuff
banks can’t hide, its so obvious they have to disclose it all.

[Reggie Comment] They can’t explicitly
hide it, but they don’t have to because the European regulators,
central bankers and politicians are complicit in allowing the banks to
declare that these « toxic » assets 1are risk free and to be carrier at
par. You don’t have to hide the truth if lying is legal! Very similar to
the US situation, although I believe the US has a stronger overall
economc potential. That is "potential" not necessarily existing economic
activity. Currently, I believe the US consumer to be economically "dead
in the water" with many corporate financial statement in tow!

We can see the whole European banking sector destiny is hand in hand
with the states finances, their balance sheet being so loaded with the
stuff. Having worked in a bank, I can tell there are much worse things
to come that’s not even in the financial reports ! Also, regarding the
French banking sector, I tend to believe most of the PIIGS exposure is
in the less sophisticated players.

Thats why the govts will try to prop up the banks. IMHO an analysis
of a contagion effect should include not a sovereign exposure but
interbank + sovereign exposure - because of the leverage.

We have attempted such an analysis
with the BoomBustBlog Sovereign Contagion model, although this was more
of inter-sovereign linkage than a direct interbank linkage.

The result of this “Great Global Macro Experiment” is a market crash that never completed. BoomBustBlog subscribers should reference File Icon The Inevitability of Another Bank Crisis while non-subscribers should see Is Another Banking Crisis Inevitable? as well as The True Cause Of The 2008 Market Crash Looks Like Its About To Rear Its Ugly Head Again, With A Vengeance.

If Greece defaults, Greek banks (at the very least) become instantly
insolvent, and the Greek depositors would probably be on the hook.
Domino effect, thats your scenario.

The Greek banks are insolvent now.
There’s really no way around it. They have had multiples of their net
equity invested in Greek bonds at 30+x leverage and those bonds have
devalued by 50% of more. They haven’t been solvent for some time. If you
remember last year when  illustrated How Greece Killed Its Own Banks!,
you realize the main reason why the EU has been using the kids gloves
with the Greeks. To make a long story short, let’s employ the old adage
“A picture is worth a 1,000 words”…

Insolvency! The gorging on quickly to
be devalued debt was the absolutely last thing the Greek banks needed as
they were suffering from a classic run on the bank due to deposits
being pulled out at a record pace. So assuming the aforementioned drain
on liquidity from a bank run (mitigated in part or in full by support
from the ECB), imagine what happens when a very significant portion of
your bond portfolio performs as follows (please note that these numbers
were drawn before the bond market route of the 27th)…

The same hypothetical leveraged positions expressed as a percentage gain or loss…

Add to this the reports of
incessant runs on deposits at Greek banks as depositors (wisely) move
their funds to safer horizons, consequently increasing the implicit
leverage upon which said Greek banks operate and eliminating any
cushions provided by ECB bailout!

Who would want to leave his money in a Portuguese bank and so on, if
depositors lose their money... Bank runs, the system would collapse
quickly. By the way, in that doom scenario, i can't see how even US or
Japanese banks can go unscathed through their interbank lending and
derivatives operations.

But lets say ok, were going to have those 50haircuts on the PIIGS.
According to your figures, thats a 2 trillion (50% of 4 trillion )
problem. Well we've seen trillion bailouts in the US, we can certainly
do it in Europe. And also as its governement debt, there is still plenty
of power to tax. All forms of taxes going up everywhere is the 100%
safe bet.  Loss of liberty for citizens seems also the trend.

I will continue this conversation, as well as at least one other, later on in the day. In the mean time...

Online Spreadsheets (professional and institutional subscribers only)

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Zero Govt's picture

Great information Reggie, Many Thanks :))


falak pema's picture

Reggie one question to you : suppose you are right on the arithmetic and wrong on the politics; how long can the political show hide the fact under the carpet given the fact that every currency and every sovereign state worth the state is telling lies. We are now in 1931... and nobody wants to admit he is naked.

disabledvet's picture

All eyes on the most beautiful place on earth: France.  Given Fukushima and France's total reliance on nuclear power and obviously what you have been saying for since Day One Reggie and the speculators have The Republic in the cross hairs and probably have for some time.  Given "power politics" trumping all else these days (does anyone care about beauty anymore?) and "reports of 1940" on Seeking Alpha and I fear for one of our great allies and friends.

midnight's picture

The PIIGS is a failed script and the fundamentals are not there. The U.S. will be the next in trouble

AccreditedEYE's picture

Reggie, great stuff. You should go back on Fast Money and tell that ass who runs Sky Bridge Capital to load up on this great "value play". lol

schoolsout's picture

Always good stuff...

For some reason, you remind me of the guy on the Right Guard commercial...

dcb's picture

well done post reggie, It's a bit more profesional sounding without some of the "chest thumping". Sorry if the term is insulting, that wasn't my intent, just lack of a better word (self promotion perhaps? ). When you are a key note speaker or on TV, the links and video do the work for you so commentary is excessive.

LawsofPhysics's picture


Glad to see you getting back to sticking to technicals.  What is your prediction regarding when all the "mark to unicorn" accounting comes to an end?  The way I see it, things will continue to crash so long as true price discovery is being blocked by essentially everyone in "control" of the financial sector and government.  More directly, please comment (from a technical perspective) on what happens to precious metals (both physical and paper futures) when the world forces a de-facto gold standard upon all markets in lieu of extending "mark to unicorn" forever.  People in my neck of the woods already interested in trading coins and PMs for services.  For example, I am running another sewer line on one of my properties and all those involved want cash or coin for their services.

The way I see it, despite the current financial repression being implemented by TPTB, true price discovery will find its way back to the real economy one way or another, and that is all that matters when one is in the business of making things of real value (unlike the financial fucknuts that claim almost 30% of America's GDP - another topic altogether that is NOT sustainable and will not end well).

Many local farmers very interested in taking cash and coin for services.  Now where in the history of the western world have I seen this occurring and what followed?  Hhmmmm.

P-K4's picture

Reggie, everytime I read your articles, I feel like I am taking a final exam in thermodynamics using a slide ruler and after a night at the frat house with their "buy one, get five free" drink special. I long for the Cliff Notes version or send me back to DTCC school.

sunkeye's picture

'buy 1 get 5 free'  thnx made me laugh w/ that1


White.Star.Line's picture

Sometimes it's hard to see the scope of theft when there has been so much legislation, accounting changes, and financial "products" added to the system.

Economic and financial concepts are really quite simple, once you eliminate the bamboozlement and misdirection.

virgilcaine's picture

Robo gets wet over a dead cat bounce in a bear mkt.