Over the three years since I have been publishing BoomBustBlog, I have amassed what many consider a remarkable track record,
having called nearly every major market crash and large financial/real
estate/bank collapse over said time period. Believe it or not, many
have even went so far as to call me “intelligent”. While I would love to
bask in the light of potential admiration, let me assure you, although I
am in no way lacking in confidence or ability, I am also quite average
in the intelligence arena. While not being any more intelligent than the
average man, I do have an uncanny knack for seeking out that rarest of
rare concepts these days – the TRUTH! This increasingly uncommon ability
(to both speak and seek the truth) has served me quite well in both my
investing pursuits as well as in the personal aspects of life. Let’s
delve into how I translate this personal talent into a product that I
distribute from my BoomBustBlog, and then into the facts in regards to
the current state of concentrated risk in today’s US banking system – to
wit, the systemic risk of derivatives concentration.
This time around, instead of Time Saving Truth, I believe that
The full 3rd quarter forensic analysis and valuation update for JP Morgan is now available for all subscribers: JPM 3Q 2010 Forensic Update. The download is a much more detailed version of the (not so) quick overview I posted the day after earnings
that reveals some very interesting points. All in all, the JPM quarter
was quite bad, considerably worse than the media appears to be making
it out to be. I have taken the liberty to include some of the
highlights of interest in this blog post. While the hardcore actionable
stuff is reserved for clients, I feel there are a few topics of
discussion that demand public attention. I would like anybody who reads
this to go to their local broker (or prime broker) and get a copy of
their JP Morgan quarterly research opinion and update – regardless of
the source(s). If the four issues that I have discussed in this blog
post are NOT PRESENT in your (prime) broker’s report(s), I respectfully
request that you do yourself a favor – subscribe to BoomBustBlog.com
and download the report linked above, which includes valuation as well.
I will be offering an extra download for professional and
institutional subscribers interested in granular, detailed loan,
charge-off and derivative holdings in the near future.
Other subscription-only downloads of recent interest pertaining to this topic:
The Truth (as defined by Wikipedia):
can have a variety of meanings, such as the state of being in accord
with a particular fact or reality, or being in accord with the body of real things, real events or actualities.
It can also mean having fidelity to an original or to a standard or
ideal. In a common archaic usage it also meant constancy or sincerity in
action or character. The direct opposite of truth is “falsehood“, which can correspondingly take logical, factual or ethical meanings.
Far from being an adherent to conspiracy theory, I must admit that I
have bore witness to, at the very least, a lack of the dissemination of
the “Truth” throughout the popular media and even corporate financial
reporting, with the apparent blessings of the regulators that over see them.
At the worst, it is the purposeful spread of misinformation and
disinformation with the intent to deliberately mislead, sourced from
several formidable parties in an attempt to maintain the status quo – a
status that has long seen its hey day as both the main beneficiary and
the harbinger of a most unsustainable credit and asset bubble.
This bubble, contrary to popularly disseminated belief, was very easy
to both see coming and to ameliorate before it actually popped, but the
economic policies of this nation encouraged the dealing with bubbles
after they popped as modus operandi, consciously opting to have the
nation (and consequently the world) go through massive surges, lurches
and crashes as a result – in lieu of smoothing this most violent
Considering the sheer size and quantity of relatively new and
untested assets at stake in this last cyclical economic bubble blowing
session, one should be aware that the stakes are now larger than ever.
The following is a chart comparing JP Morgan’s notional derivative
exposure to worldwide GDP and is one of the most popular and
controversial charts on BoomBustBlog. The basis of the chart is that JPM
faces very material counter party risk – trillions even.
Of course, all of those guys who are intelligent, and arguably much
so than I may be, declare that looking at notional value is both
meaningless and misleading. Of course, I disagree. You see, notional
exposure denotes exposure and as a result also clues you into counter
party risk. After all, if you are exposed, then you are exposed to
something through somebody. Alas, I embarked on a project last year to
put those oh so intelligent naysayers to rest.
We looked at the whole kit and kaboodle, notional value of
derivatives, gross fair value of derivative (before netting) and net
fair value (after netting) for leading players in the industry and have
compared them across various metrics. Again, that many of those
hyper-intelligent guys, the ones that no mere financial blogger could
possibly hold a candle to, assert that derivative values and exposure
risks are often overstated due the fact that much of the risk is netted
out. But, my dear friends of ivory tower and Street of Wall, if you are
netting your exposure against and/or with a third party then you are
relying on that party(s) ability to make good in the event bad times
comes a knockin’. Therefore the truth dictates that essentially, you are
simply swapping market risk and/or interest rate risk for counter party
risk, which is in essence credit risk. Soooo…. Despite the fact that
you may be more intelligent than I, and even many more financial
bloggers, it is at best, misinformation, and potentially disinformation
to claim that risk is eliminated through netting. It, like matter
itself, is simply transformed. With that concept, or clarification of
concept, in mind let’s move on to what we found last year to cause me to
draw those colorful JP Morgan charts (this work was performed Q$ 2009).
- On an absolute basis (dollar amount), JP Morgan is the leading derivative player in the industry with notional value of derivatives amounting to $80 trillion followed by Bank of America and Goldman Sachs. JPM also has the highest gross fair value of derivatives (before netting) with $1.79 trillion of derivative assets and $1.75 trillion of derivative liabilities.
- Despite its higher gross fair value of derivatives, JP Morgan’s net
exposure on balance sheet is not the largest (with $97 bn and $67 bn of
derivative assets and derivative liabilities, respectively) as the
company has netted a significant part of its derivative exposure (traded
market risk for counterparty risk). The net fair value of derivative
receivable to gross receivable for JPM is 5.42% compared to industry
average of 9.84% while net fair value of derivative payables to gross
payables for JPM is 3.84% compared to industry average of 6.03%.
- JP Morgan’s total derivative exposure on balance sheet is $165 bn,
or 174% of its tangible equity. JPM’s gross fair value of derivatives is
approximately 38 times its tangible equity while notional amount of
derivatives is about 850 times its tangible equity.
- On a relative basis, HSBC and Morgan Stanley have the largest on
balance sheet derivative risk exposure with total fair value of
derivatives, net (asset and liability) forming a staggering 683% and
508% of their tangible equity.
- As of June 30, 2009 Morgan Stanley’s’ total gross fair value of
derivatives to tangible equity stood at 114x. Those who have followed my
blog since 2007 know that I know Morgan Stanley as the riskiest bank on the Street (since both Lehman and Bear are now gone, as I anticipated, see A
Chronological Reminder of Just How Wrong Brand Name Banks, Analysts,
CEOs & Pundits Can Be When They Say XYZ Bank Can Never Go Out of
Business!!! for a blog by blow on both of those calls).
I wil be picking apart MS and GS, as well as updating my reports with
data from the latest quarter shortly, but for now, let’s continue the
examination of derivatives risk and exposure with the poster child, JP
Morgan – whose portfolio quality is much poorer than both that of Lehman
and Bear Stearns at the time of their respective collapses.
Best viewed in 1080p HD, expanded to full screen…
But the question of the day that I get from those many who very well be more intelligent than I is, “What does this mean? How do you know there is counterparty risk in lieu of you simply blogging that there is?“
Well you see, this is where good ‘ole common sense comes into play.
When 5 banks control 96% of the notional derivatives value outstanding, I
query, “Who the hell else could they be facing besides each other?”
Hey, let’s not forget this one (again), “Hey Dude, that risk is reduced
with hedges and offsetting positions!” Yeah, I know, just as Lehmans and
Bear Stearns’s risk was, right??? Again, you don’t offset the risk
exposure, you simply transform it. You move it from the market risk
category to the counterparty risk (opposing party credit risk) category.
That risk happens to be compounded, amplified and exaggerated when you
have 96% of the exposure concentrated within a pool of 5 gigantic
entities that are essentially in the same business, using the same pool
of talent, with the same operational criteria and habits, who went to
the same schools to learn the same (and often lame) risk mitigation
techniques, to essentially trade the same products in the same markets,
during the same or similar time frames. Tell me again, exactly where did
this “netted” risk disappear to within this group of five banks that
face and hedge everything with each other???
Netting only offsets risk if the counterparty you are netting
against has the ability to pay up in case of an event. If that party is
using you to fund his hedges, and you are him to fund your hedges, and
the other 4 guys in the room are doing the same with each other and
you – all in the same markets with the same or similar products, then
where is the capital going to come from to fund the actual loss? All
that was done was to pass the risk along a circle of 5 banks, and that
risk actually landed squarely back in our lap, disguised as netted
derivative exposure, commonly known in Brooklyn as Bullshit! When the
shit does hit the fan, and those 5 big fat intelligent boys run for the
exit in a nearly 100% correlated movement of allegedly diversified and
hedged (netted) assets, not all of them are going to fit through the
Provided the event is big enough and common to all players involved
(ex. MBS/real estate related, mortgages and loan derivatives ala
Fraudclosure -hint, hint, wink, wink) you will see a correlation of 1.0
and a massive run for the exits. Everybody will just look to the next
bank, who will look to the next bank, etc.
To be clear, all of these banks have in excess of 100% of their
tangible common equity exposed to counterparty risk. BAC has 1200% (most
likely severely understated, but that’s a story for another time) and
JPM, GS and Citi have over 2000% exposure. If something kick’s off in
one of these banks, the others are falling along with them - 100%
correlation as the club collapses, just as I stated to Herb Greenberg and the CNBC audience last Monday.
Do you think anybody was listening? So, next in the brainstorming pool
is the determination of what just could kick this off. Well JP Morgan’s
MBS analysts have given thoughts that are corollary to mine, JP
Morgan’s Analysts Agree with BoomBustBlog Research on the State of JPM
(a Year Too Late) but Contradict CEO Jamie Dimon’s Conference Call
Statements – although they apparently forgot to forward the memo to their CEO in time for the Q3 conference call!
Here are some thoughts from the hyper-intellectual BoomBustBlog
constituency and readership (yeah, my readers are often brighter than I
First of all, thanks for all the great research you and your team are
doing. I am interested in your opinion on an issue relating to
mortgage servicing. One thing that may fall out of this foreclosuregate
mess and loan repurchases will be (1) replacing servicer in RMBS deals
and (2) not reimbursing a servicer for costs incurred due to improper
According to Bloomberg, 56% of the market is controlled by four banks:
- Bank of America = $17.5bn (as of Sept. 30)
- JPMorgan = $13.6 billion
- Wells Fargo = $14.5 billion
- Citigroup = $6.2 billion
- total = $51.8bn
What is amazing to me is that the
bank are taking gains by marking the value of these rights up not down.
In the most recent earnings announcement for BofA they say ”The net
loss of $344 million in Home Loans and Insurance decreased $1.3
billion from the year-ago period. Revenue increased 10 percent largely
due to higher mortgage banking income primarily driven by improved
mortgage servicing rights results, net of hedges, and higher production
income driven by wider production margins. These improvements were
partially offset by a $417 million increase in representations and
These meaningful assets to these banks. I am curious to know what you think about this.
Thanks for your work.
Aren’t you actually UNDER-selling the crisis here?
Let’s look at the story again: aren’t
PIMCO, Blackrock and the FRBNY asserting SERVICER liability here? In
essence, CountryWide is behaving like a servicer who refuses to collect
mortgage checks – except in this case they’re refusing to service the
loans by “refusing” to foreclose on these properties with valid
As an illustrative counter-factual,
let’s consider how a bank would behave if it had a lot of loans to be
serviced that COULDN’T be serviced – I mean, there’s no real borrower,
there’s no house, the loan has been sold more than once, the loan
documents are all signed by “Mickey Mouse”, etc.. (You know, standard
operating procedure in 2005).
First things first, if I’m a servicer
of unserviceable loans, I am going to find a way to “refi” as many of
those loans as practicable (and thus generate all-new paperwork)
without actually reworking the terms very much. After all, doing
“re-fis” in order to kick the default can down the road is old hat for
Sounds like the counter-factual matches reality so far.
So if I’m that servicer, what do I do
if I actually have to foreclose? I can’t possibly risk sending this
garbage into a court the way I would a normal foreclosure, so I wait. A
year goes by, two years, maybe even three or four years without a
payment. I present the court with scores of default notices and no
response (because Mickey Mouse can’t write). AND, I don’t present the
judge with just a few loans. No, I BURY the judge in foreclosures. The
judge is now doing so many foreclosures on loans two and three years
without a single payment that shealmost gets to the point of
“robo-signing” foreclosure judgments herself. Occasionally I make a
mistake and somebody challenges on one of these zombie loans. The judge
actually takes time to examine the paperwork and goes nuts, but this
is just a small (but growing) percentage of my foreclosures. Dead
people and illegal immigrants who “buy” their houses from the subprime
Mafia don’t ask many questions.
Again, this counter-factual looks strangely familiar.
But what do I do on the investor
side? That’s much trickier. If I’m dealing with Fannie and Freddie,
there’s probably not much I can do to the loan pools as they generally
demand a pretty straightforward pass-through, (even with the Alt-A
garbage WaMu and CountryWide dumped on them. Fortunately, those loans
are probably a little better, and also fortunately the GSEs are not
eager to cause a lot of foreclosures, so I can delay quite a bit. But
basically if the GSEs bitch, I quietly take some putbacks. Again, this
is what we’re seeing.
Then we come to the private RMBS. At
this level, if I’m a servicer of unserviceable loans, I start to engage
in hijinks. The simplest, easiest thing to do is, again, to just let
the loans go into default for a REALLY long time. By this time, the
lower-tranche buyers of the pools I’m servicing are all speculators and
they have no time or money to examine things like why the foreclosures
are recovering only a tiny fraction of par. Here is a place where we
can test the counter-factual against reality, because this would show
up in breakdowns of the recovery data. Also, “first loss” tranches
would, I guess, start to be wound up – or is that true?
The real problem comes when I start
getting into the tranches where big investors with deep pockets (like
PIMCO) will start asking loan-level questions. I can’t just stick these
guys with horrendous losses on foreclosures all at once or they are
going to go mental. Again, the first, best thing to do is delay, delay,
delay. Again, the counter-factual and the facts match.
Still, I have a problem. If my
behavior doesn’t fit their models and assure them that the revenue will
keep coming to those pools, these guys are going to tell me to start
foreclosing and foreclosing fast. They want to get their money OUT. If
I’m an originator-servicer, or a packager-servicer then maybe I can
mollify them for a time by massaging the pools. As in: “We end up
restoring them, and they go back in the pools.”?????
Is this the counter-factual and the facts matching once again?
Finally, if I’m a desperate
originator-servicer or packager-servicer and I didn’t put the loans out
to a truly “arm’s length” entity and the securitizing agreements are
“flexible” enough, I am going to start to head off recourse by either
buying back some mimimum of vulnerable tranches myself (Santander?)
*or* by siphoning off cash to the pools somehow.
Are we seeing a lot of complex,
total-return swap agreements these days? Have desperate
originator-servicers and packager-servicers engaged in a bit of
semi-off-balance-sheet synthetic DE-securitization? Are banks being
generous with cash collateral on deals that transferred risk (but not
formal ownership) from their QSPEs back onto their own balance sheets?
Now if I saw that kind of stuff, I
would definitely start to believe that banks are dealing with a problem
of unserviceable loans.
You get what I mean.
You see that the various large shoes we were discussing have
begun dropping. Multi-billion dollar demands by non-agency bondholders
for putbacks, and now the government is being forced to take action.
I read elsewhere that a group of hedge funds is organizing for a
similar demand. I view with interest the tiny levels at which the
banks are reserving against these events in comparison with the present
(and probable future) size of the put-back demands. Again, this is
only ONE tentacle of the monster.
So far, the putback demands appear to be merely rep and warranty
driven, i.e, the failing loans do not meet the underwriting
requirements as represented in the prospectus. This does not implicate
the REMICs’ tax-exempt status. However, as claims for wrongful
foreclosure based on the failure of loans to be properly deposited into
trust are proved true — or as the same facts are brought to light by
50 state attorneys general — it will be implicated. This may produce a
larger wave of claims by bondholders, both because of the loss of tax
structure as represented and warranted, and because the knowing failure
to properly deposit the loans (which will be inferred from the
systematic extent of the failure) may support securities fraud claims.
I will be very interested to see how you quantify the size of the problem for the banks.
counterfactual. From the beginning, it has seemed to me that it should
be obvious to everyone the American mortgage market was exhibiting
“Market For Lemons” economics. A Lemons market implies the existence of
large-scale fraud – that being “fraud” relative to the normal and
customary expectations of that market, not necessarily legally
actionable fraud (although we have plenty of that). The best thing
about using fraud as a model, is that it’s both simplifying and
edifying. Because, in a Lemons market, everything that looks like a lie is, in effect, a lie.
reached, if it looks untrue, it is untrue, in economic terms. If you
make me feel you *might* be trying to fool me, I react to you as if you
*are* trying to fool me. [In technical terms - in my opinion, anyway -
the mechanism of market-clearing price stops working because
successive transaction leads to more volatility rather than better
price discovery. People consider Lemons markets unreasonable, but in
fact they are highly reasonable. They are finding value for the information
available in the marketplace.] The more opacity and misrepresentation
one encounters, the more things one should (at least provisionally)
interest rate problem or a GSE problem or CRA problem or any of that
eyewash. The public view banks as purely automatic systems. You and I
know better. We had a problem of trusting, complicit regulators
(particularly OTS), a fast-rising market and large-scale, long-term
toleration and acceptance of obviously aggressive, dishonest mortgage
originators. Inevitably, that put fraud – real fraud – into the system.
The system should have rejected it, but it didn’t, and so the die was
kind of a literal way. Clearly, the more our bankers handled this
low-level mortgage product they really shouldn’t have touched in the
first place, the more it shaped them into resembling fly-by-night
subprime originators. That dishonesty transferred through the
organizations until it came to “roost” among the professional liars of
the bond market, where it grew. And the bond market had its own
problems – very similar to the problems in the real estate market – lax
regulation, a rising market, and crooks. What was thought of as the
gentlemen’s game of “liar’s poker” for a few tens of basis points
became just plain lying. The culture of deception tunnelled quickly
through our banking system from both ends until that system became
nothing more than a conduit for fraud.
on the “bottom” end of the Mortgage Mess you’ve got fraudulent
representations through bad documents. On the top end you’ve got
fraudulent representations of cash flow. Isn’t that the bottom line? So,
the lawyers and judges will wade through the documents. Your job is to
wade through those cash flows. But it seems to me that it’s easier
than it looks. In this environment, you need to see loan-level
documentation on the bottom end, but you only need a representative
sample. On the top end, you can model UNENCUMBERED CASH positions and
test your models against outcomes – and look for anomalies and opacity.
their rationalizing arguments. Just keep finding instances where banks
and financial institutions are paying too much for cash flow and/or behaving in anomalous ways (and the anomalies are legion) . If it’s opaque, if it’s anomalous, it’s fraud – again maybe not legal fraud but de facto,
market fraud. A Lemons model tells us this is about markets operating
on suspension of disbelief until they fall apart once they reach the
tipping point of disbelief.
There’s, what, $1.4 trillion in securitized real estate loans?
There is some inevitable-but-unknown degree of recourse between that
debt and the banks’ balance sheets and financing aparatus.
Every day, very smart people work very hard to, in effect, spread
that risk across those balance sheets and to finance it at the lowest
loss rate possible. Eventually – as with IndyMac’s brokered deposits
and Bear Stearns’s mortgage repo – a part of that financing arm will
become overstressed and people who are happy to finance that liability
now are going to change their behavior.
“The Market” is not going to solve anything. It’s as if there is a
membrane between yesterday’s and tomorrow’s financial reality.
Yesterday’s financial reality will survive so long as that “membrane”
doesn’t have a hole in it. You’re looking for the size of the possible
problem. They’re looking for the hole so they can patch it up.
In the end, their problem will not be excessive optimism or
deception. They can handle those things and they have done. Their
problem will be institutional inertia. Their downfall will be the
experience-justified belief that things will go on as they have been –
until suddenly they don’t.
You’ve proved the potential for the problem. The question is when
and where does the music stop? Who in the industry is loaning money,
accepting collateral, processing papers – just doing business – who will
suddenly decide: “You know, I don’t think we’re gonna do that
tomorrow. That could get us into trouble.” That will be your
breakthrough: when you figure out who is funding/cooperating/doing
business today who is going to demure tomorrow.
Thanks for your work.
For those with short memories, here’s the refresher in how everybody
denied there was a problem (except the BoomBust and a very, very small
coterie of realists) in 2008, and how this not so intelligent guy that
persistently seeks the truth easily called the fall of those big banks
that fell well in advance, even as Goldman, bank executives, big sell
side analysts, regulators and ratings agencies all assured us that all
was well, up until the actual collapse : A
Chronological Reminder of Just How Wrong Brand Name Banks, Analysts,
CEOs & Pundits Can Be When They Say XYZ Bank Can Never Go Out of