A Step by Step Guide to Exactly How Much Derivatives Risk Each of the 5 Big Banks Actually Have, and How It Could All Go Boom!

Reggie Middleton's picture

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.

Time Saving Truth from Falsehood and Envy, François Lemoyne, 1737

This time around, instead of Time Saving Truth, I believe that
Truth can save Time (to true economic recovery, not politically strewn
machinations of “green shoots”), particular as said Truth goes Viral!!!
Close your eyes and imagine, descending upon the masses through this
“new media” called the Web-  brandishing that “Fiery Sword” known as 
Truth (see below), slashing through falsehoods, misinformation and
disinformation to arrive at the true state of affairs…

The full 3rd quarter forensic analysis and valuation update for JP Morgan is now available for all subscribers: File Icon 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.

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.[1]
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.[1] 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
economic cycle.

From “The Great Global Macro Experiment, Revisited

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
    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.

Put graphically…

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
– 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:

  1. Bank of America = $17.5bn (as of Sept. 30)
  2. JPMorgan = $13.6 billion
  3. Wells Fargo = $14.5 billion
  4. Citigroup = $6.2 billion
  5. 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
warranties expense.”

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.

Reggie Middleton,
Thanks again for your work.
I’m glad you enjoyed my
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.

Once the Lemons tipping point is
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)
I’ve never believed that we had an
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
And I mean “the die was cast” in
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.
Anyway, sorry to go on and on, because it’s all pretty simple, really:
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.
Everything else is crap. Forget
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.

From “the industry”? Nah, I’m just a guy from Jersey – raised as you were with a sense of what a scam looks like.

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

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bingocat's picture


The title, "A Step By Step Guide to Exactly How Much Derivatives Risk Each of the 5 Big Banks Actually Have, and How It Could All Go Boom" is probably overstating what you have presented here.

Your derivs exposure "analysis" is the same as last time when at least one other "pro" commentator posted some analysis of your analysis (in the commentary to your post about JPM's aiding and abetting insider trading on 10b5-1 sales plans), and the conclusion was that actual low-grade counterparty derivatives exposure (which is surely collateralized under their CSAs) was far lower than sub-IG lending exposure to corporates (which is often collateralized too) and lower than your numbers suggest.

As I wrote there, the derivatives PROBLEM is not that there are 5 banks. They have very active CVA desks to cancel out those issues. The "correlation problem" is that the tens of thousands of corporate clients of JPM and other banks are usually all in the same direction. And if they all suffer at the same time, JPM will go on seizing collateral or unwinding trades according to ISDA/CSA documentation.

What this means, as it did with Lehman, is that while banks are well-protected, senior unsecured creditors (bondholders, etc) are going to have much lower recovery ratios in any bankruptcy than most people model/expect. The substantial increase in collateralized derivatives exposure for banks is actually a boon. It allows banks to demand more collateral/margin almost constantly, turning their business into secured lending while unsecured lenders (non-collateralized loans or bonds) are much more like contingent equity - if TSHTF, they own equity, not debt, because the collateral seizure mechanism has a downward spiral effect on the asset prices which represent both the collateral available to be posted and the assets available for recovery post default event.

Once again in reply to one of your posts citing the Lehman experience, I am obliged to remind you that Lehman did NOT go down because of its derivatives exposure. It went down because a) real-time liquidity provision on a NON-collateralized basis dried up, and collateral values were disputed, and b) the funding ladder Lehman ran was a colossal risk management screwup. It was bad risk management plain and simple. One thing remarkable about the Lehman bankruptcy was how little effect it had on global bank counterparties (the 5 big banks, among others) where there was sufficient collateral posted according to the CSA. As noted above, the problem was that senior unsecured creditors of Lehman got hosed. This points out how much better it is to have derivative exposure to banks than to have notional credit exposure (by buying their bonds or lending them money), and it illustrates the importance of understanding collateral and collateral risk management systems.

What I want to see is analysis which tells me what would happen if one separated out the entire derivatives business, and all its hedges (both internal and external) into a separate box, and then analyzed the factor sensitivities of that business to interest rate curve risk, equity prices, real estate prices, etc, THAT would be interesting. My bet is that such analysis would be impossible to do on the basis of public data, and until one can see the portfolio, and shock it, speculating on their and other banks actual risk management practices regarding exposure and collateral management is almost useless.

Until then, the REAL risk is sudden market "appreciation" of an imminent onset of something like a Great Depression II and the impact that has on everyone at the same time. That is not a derivatives risk. That is an "everything risk."

AUD's picture


"The creditor banks had helped to finance the boom by 'confining' themselves to a most 'liquid' asset, to credits granted to other (foreign) first class banks. What could look more liquid than a balance with an A-1 bank? But what guarantee did the creditor have that the debtor bank would keep liquid in its turn?"

Melchior Palyi, 1936

tony bonn's picture

"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."

and in his spare time he invented the internet....

actually this was a good article refuting a lame spook who wrote here last week or so claiming that we needed to embrace financial innovation defending derivatives on the very basis refuted here...

a grey swan would be sufficient to cause a catastrophe. a white swan with a black speck would be enough....and yet this crooked mess is to be embraced....my fat ass...

Wolf in the Wilds's picture

Hi Reggie,


As much as I would like the banks to do down, I do believe derivatives exposure is not necessarily the axe that chops off their heads.  I have been in the industry for a long time and derivative counterparty exposure is something I am very familiar with.  I do agree counterparty risk is a major issue, only to the point that counterparty risk transforms into market risk when the counterparty defaults.  The actual exposure between counterparties at the point of default is capped to a large extent by the collateral agreements between them.  HOWEVER, if the counterparty defaults, the bank may have to reestablish the trades that they had with the counterparty.  This is the act that leads to massive market dislocations, which may or may not result in losses. 

As to whether there is enough collateral out there for US$80trn notional of derivatives, I do believe there is given that most derivatives valuation are a lot less than the notional.

Of course, this is premise on the CSA being above general liquidation/bankruptcy laws (we saw that they were in the case of Lehman's demise), where the collateral is not subject to general distribution in the event of a default. 

The main RISK has always been REPLACEMENT risk.  And the resulting dislocation can cause major economic shocks. 

anonnn's picture

Reggie, awesome perceptions and analysis.

Brooksley Born remarked that she could discern no rationale for the very real Greenspan/Summers/Rubin et al drive to suppress regulation.

As a minor observer, I can only postulate wildly what may be afoot. 

But... since the 16th century [!][English] Hakluyts began their data collection of all global resources, thru modern Anglo-American moves in "resource wars", there is surely s/g afoot!

 The only 4 BigOil giants are Anglo-Amer:  R D Shell/ BP/ Exxon/ Chevron; and along with the short tail of cheap petroleum production, are surely a piece of the drive to dominate resource allocation.

I submit the financial "mess" was caused, somehow, in concert with the urge to dominate, albeit perhaps not going as planned. And the English know well how to operate via proxies....they are, curiously, a small island nation...and coinkydinky like Japan, do/did project enormous influence.

Global resilience, to withstand unplanned disruption, is at an historic low...an enabler of  Black Swans.

ptolemy_newit's picture


Please post your research and analysis that support your posts, I am looking for balance before.

well purgatory is waiting for you!


Coldfire's picture

You don't hedge the risk, you transform it. Excellent point, Reggie. Ex.cell.ent. Generally speaking there is - in fact - zero hedge. Netting under ISDA has been shown to work in a bankruptcy (ie., post-hoc) situation for a single firm. But the assumption that total risk can be timely netted in a systemic crisis is breathtakingly facile, mendacious, or both. The regulatory derivatives scheme is a Babel Tower of complexity, a sweat act of subjectivity, whose price signal failures will be its undoing. As this scheme goes, so goes JPM.


jm's picture

But the assumption that total risk can be timely netted in a systemic crisis is breathtakingly facile, mendacious, or both.


I'll take the other side of this. We really don't know how things will turn, no?

We are entering a world of exchange trade instead of OTC, which implies no Lehman-type "I'm not paying to a defaulted counterparty" events.  So past precedent may be useless.  I ask:  why SHOULD settlement be so hard given a clearinghouse?  You lose your reserve fund and ALL your collateral if you try to cheat the house.

While we're on the subject, collateral exists and you aren't factoring it into your adjectives.  I know that at least some hedge funds have to post 100% on NOTIONAL.  I don't know for sure about other parties, but collateral offers a non-trivial moment of clarity re: timely netting.  

Maybe one should worry about the predicates: liquidity management, risk exposures, and model (conceptual and emotional) failure. 

Coldfire's picture

You are right, the posting of collateral should be factored in. And clearinghouse settlement would fundamentally change the picture for the better, but only for new issuance. The problem of post-hoc clearinghouse migration of existing instruments is intractable.

RockyRacoon's picture

Unbelievable.  How does this house of cards stand?  The next destabilization will be a nightmare scenario come true.

Excellent work, Reggie.  Thank you for your work.

Fred Hayek's picture


I've seen video clips in which Chris Whalen says, pretty categorically, that JP was the one bank that he knew of which correctly transferred the note in the mortgage backed securities it created.  Is there a chance that JP remains standing as others fall simply by having done a little paperwork efficiently?

Reggie Middleton's picture

I can say, without a doubt that WaMu had one of the more inefficient and error prone systems. JPM bought WaMu, so even if JPM was that good, unless they straightened the WaMu mess out very quickly, well then...

bullandbearwise's picture

A lot of this risk is mitigated by zero-bound interest rates. Which is why it is impossible for rates to move up again in our lifetime...

jkruffin's picture

The easiest way to bust this fraud once and for all, collapse these scam institutions, and put the market back in proper order is simple.  Everyone in this country, and around the world stop paying mortgages.   Plain and simple.  If they try to foreclose, have ammo and barrel in hand with your nieghbors on your property.

Neither the FED, ECB, BOJ, or any other country central bank is going to step inside that realm.  There was a reason Lehman and Bear were sacrificed.  They had the lowest exposure and the cover-up was implemented.  Wells Fargo might want to watch out, because they might be the next Bear/Lehman victim.

But like I said, the only solution is fight fire with fire, and stop paying these scam bankers.  The house of cards will collapse so fast if you blink you might miss the crash.

junkhand's picture

TBTF going down=401ks going down=pension funds going=states going down=cities going down=euro banks going down



dream on.  we are just brushing the surface of this unwinding.  it is like the cold war.  only most folks never even heard about this buildup of weaponry.


Buck Johnson's picture

Good job reggie, good job.  Many people don't understand what is at stake, and if they did they would be running these people and their enablers out of the country.  This game that is being played can not go on for much longer and the markets outside the US and the financial institutions know it.  The western banking system is insolvent, they have played a game of leveraging debt upon debt upon debt and causing it fiscal responsibility. 

AUD's picture

An interesting question is what risks to its own credit would the Fed see if it 'settled' these liabilities?

Going on the results of last time, I'd have to say that the Fed would have no qualms about taking on these debts.

After all, by any objective measure the Fed is illiquid, insolvent &/or bankrupt & has been for years. Yet the USD is still 'money'. So much so that foreign holdings of US debt is at record highs.

jkruffin's picture

"So much so that foreign holdings of US debt is at record highs."

The FED is the 2nd largest holder of US debt, and soon to be the largest. Those like China that hold large amounts of US debt are going to front run the FED out the door since Bernanke likes to telegraph everything he does to the world.  Then the bond bubble bursts.  Americans once again become rape victims in the process.

Bob's picture

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 door!!!

Reggie, I'm being lazy here, but tell me this.  If this is truly the circle jerk you say, would it not suggest that if TSHF, then the Big 5 will go down, but they'll take virtually all of the CDO risk with them? 

A lot of paper money lost, to be sure, but it would seem like a relatively small price to pay to effectively dissolve the absurd universe of CDO's while at the same time getting rid of the systemic cancer of the TBTF's?


sgt_doom's picture

Sweet, Reggie my man, very sweet.

And this is exactly why the Treasury Dept.'s Office of Debt Management, and the Usual Suspects, don't want to ban naked swaps, while the Euros do.





Vorpal1's picture

So much info and hedge beef!! RM - Can you explain why the 2B2F (not porn) big banks on your list shouldn't "drop to Zero" over a short enough time period? And why does being intelligent have anything to do with money?

gwar5's picture

The derivatives bubble is the scariest to me. It's an unregulated high wire act with no net.

In 1998 the LTCM meltdown came just 8 weeks after Brooksley Borne was kicked out as head of the CFTC, under duress of congress, due to Robert Rubin, Larry Summers, Timothy Geithner and Alan Greenspan ferociously ganging up on her.

They were extremely fearful of any regulation, or light, shed upon the dark derivative markets.



TheMonetaryRed's picture

Reggie, is the problem the rating of JPM's exposure or the fact that the falling rating may reveal a statistical "hump" of bad credits hidden in aggregate numbers?

tallystick's picture

Reggie, what's your take on hybrid CDOs?  How much real collateral got intermixed with derivative nonsense in these cash/synthetic hybrid monstrosities?



Eternal Student's picture

This is superlative work, once again, Reggie. Thank you.

There's one thing that I don't understand though. If the big banks have a total of around $200 Trillion in derivatives, and the world-wide market is around $650 Trillion which are known (according to the BIS), where's the other $450 Trillion?

StychoKiller's picture

When you touch a lit match to a pile of gunpowder, does it matter where?  Once the first domino falls, we'll find out the answer to your question rather quickly.  Will it matter if, let's say France, owes everyone $200Trillion vs $100Trillion?

Eternal Student's picture

You raise a valid analogy, and yes, I do believe it matters where. To use your gunpowder analogy, if you don't see the lit match, then the explosion does seem instantaneous. If you do see the lit match, you've got some time to make final preparations and anticipate; as opposed to being under "shock and awe".

While these collapses happen quickly, they are not instanteous. Not even the crash of 1929 was. It played out over days, and if you got out on that last Friday when things were looking up, you may have gotten out with profit. Again, we saw that back in 2008 (heck, I saved a bunch of money back then).

This is why I'd like to be looking for the lit match.

sgt_doom's picture

Some in play over the various exchanges, others parked at various international public-private partnerships, at various financial institutions and services:

Macquarie Group, Credit Suisse FB, Deutsche Bank, Barclays, UBS, held by all those opaqe global hedge funds, sovereign funds, funds of funds, LBO funds, pension funds......

Eternal Student's picture

Thanks. And yes, but what I am wondering is more along the lines of how it's broken down? I.e. is JPM the biggest elephant on the planet, or is there a bigger one which is more exposed? For example, Credit Suisse has a well documented (to put it politely) reputation of playing fast and loose.

Or even a breakdown by continent? For example, the impact of Greek bonds on this House of Cards. Or perhaps even Ireland giving their bank bondholders a haircut?

I've suspected that the bigger risk is really from the countries on the central European periphery, while everyone is more focused on U.S. Real Estate. I was wondering if anyone anywhere has really looked at this and published some numbers?

ConfederateH's picture

Reggie, I haven't seen you send a broadside into the Swiss banks lately.  What's your take on their current situation?

Jasper M's picture


   Give In to your Hate, and Join Me, on the Dark Side!

Chemba's picture

How did western civilization ever develop without the blinding insights of Reggie Middleton?

By the way, calculations using notional value are highly misleading.  The credit exposure on a financial derivative is not the notional value.  Since Reggie is the smartest man in the world he must understand that, but perhaps the hyperbole inherent in the "analysis" is helpful in selling subscriptions.

Panafrican Funktron Robot's picture

Interesting that he was humble enough to explicitly state that other people were smarter than he was, but you still had to throw the bomb anyways.

Regarding your comment on notional vs. net, seems pretty obvious from, you know, reading the actual article, that he was pointing out how small the net loss had to be to completely nuke these banks.  I would suggest taking off the blinders and actually reading it, most of us are not in the Reggie fanboy club and I'm assuming he would want that club to have zero members, but you come off as sounding pretty retarded when you post shit like this.

Reggie Middleton's picture

Maybe Chemba failed to read the whole article, referencing counter party risks, fair value, netting and other issues. Why bother reading the posts if you don't like them.

Chemba's picture

Your analysis includes a sensitivity of tangible equity to losses as % of notional value, so, regardless of what you "say", you are explicitly assuming that the credit risk is equal to notional value.  As an aside, you have no way of understanding (from the outside) how exposure to counter-parties net and cancel.

It's not a question of "not liking" your posts.  I am simply pointing out that the analysis has flaws and is "sensationalist".

You seem a smart guy, as a marketer certainly.  Were we back in the hey-day late 1990s I'd recommend you for a sell-side position at a bulge bracket bank.  But if your insights were as powerful and investable as you claim there would be no reason to sell them.  Instead, you'd simply rack up the returns on your own (and others) capital.  Sell siders do analysis and sell it, buy-siders invest.

Reggie Middleton's picture

Again, you fail to read what it is you comment upon. The notional value argument is thoroughly addressed. I have no problem with you pointing out weakneses, but the article has to be read first. You obviously didn't read it.

As for whether I act upon my own advice, that is all I do. Whether I fit "your" idea of a sell side or buy side agent is highly irrelevant. I'm an independent hence if I want to sell my opinion or research, then I will do so without having to fit into traditional labels.

Not everybody wants to run money, particularly other people's.

sgt_doom's picture

"As an aside, you have no way of understanding (from the outside) how exposure to counter-parties net and cancel."

And neither do those on the inside, douchebag!


TheGreatPonzi's picture

With all the sovereign debt stories going on, people quite forgot that derivatives were actually the worst danger. Good reminder.

DaveyJones's picture

Mutual Assured Destruction: and to think we were afraid of nukes

anonnn's picture

from Charles Dickens "Little Dorrit":

person who can't pay gets another person who can't pay to guarantee that he can pay. Like a person with two wooden legs getting another person with two wooden legs to guarantee that he has got two natural legs. It don't make either of them able to do a walking-match. 

 [any color is a format error]

gousnavy's picture

Taleb's "Black Swan (an unforseeable and unpredicatble event)" is the financial equivalent of DEAF CON 5. Reggie's analysis drops it to less than 5. Right on Reggie. Keep trying to turn the nuclear financial clock back from 12 AM.

Ancona's picture


World governments won't let these behemoths get broken up for a very simple reason; they know that many of the banks assets are either imaginary [marked to unicorn] or so badly compromised that a break-up would expose just how bankrupt these institutions really are, collapsing world banking overnight.


The risks to world commerce are just too huge to shut these monsters down. All commerce would cease nearly immediately if the ten largest banks were placed in to a resolution trust situation.


As usual, your insightful information is too much for a mere engineer to digest all at once, so I'll save most of it for later, when I can kick back in the 'ol barcolounger and digest it properly.


Thanks for your contributions Reggie. [And thank God you don't work for "them"]

The Axe's picture

Hey,,Reggie..haven't seen you post on PPD (Reggie = Large PPD hater) seems like there "might be" a PE bid of $60 for PPD, its at a 52 weekly high. Now 10 times book value is high for a private equity firm, and I don't believe management...but $63 is 63 dollars... 

Reggie Middleton's picture

Yes, 63 dollars is still 63 dollars just as a ponzi scheme is still a ponzzi scheme. Bubbled stock prices don't cause me to waiver in my opinion. Didn't BSC sell for 180 dollars 6 months or so before their ponzi collapsed?

web bot's picture

I'm not even smart enough to comment... but nice work.


hooligan2009's picture

The quality of your work just keeps getting better!

Had this conversation about counterparty risk a year or so ago with JM.

The key points I had were that the net P/L per derivative position were largely collateralised via Credit Support Annexes (CSA's) to ISDA's. Hence the players think that counterparty risk is entirely mitigated by daily collateral posting (and substitutable according to terms in the CSA).

I maintained that within the (pick a number) $700tn derivatives market there was insufficient collateral in existence to cover the existing net p/l of all derivatives and that gap risk was the event that would prick the bubble. JM thought that most positions were 1-3 year interest rate swaps and weren’t collateralised. The industry went through a huge net off exercise post Lehman’s in March 2009 I think.

Many CSA’s specify haircuts in proportion to the credit rating of the collateral pledged. I don’t know but guess that the highly rated collateral used to secure p/l on derivatives is now doubtful. The ratings agencies are silent for “foreclosure gate” and are back in the firing line for also not verifying the content of mortgage pools.

We now have to wait for the rating agencies to follow the leading analysts such as you; once more they are reactive, not proactive.

This is not to say that the credit ratings of the banks themselves aren’t suspect (Fitch has moved a little I think), but the mortgage market is suspect. It can only be a whisker before investors simply pull out because the market is broken (fraudulently based).

The other risk (aside from collateral risk) that I fretted about was duration risk. That is “mind the gap” spike in Treasury bond yields. As soon as it becomes apparent that we have a normal 2+2 GDP and CPI economy (may not happen and we are now Japan, but let’s say it does), the yield curve will gap upwards to reflect a 4% Fed Fund rate and a positive curve with the ten year at 4.5% from 2.5%ish now.

The p/l impact on $700tn for a move up for every 1% increase in Treasury yields with an overall weighted duration of, say 6 years is in the trillions, drop this number for the hell of it by 75% and you still get a $1tn collateral call.

The biggest counterparty risk is the Fed though, since it is the lender of last resort to the banks.


jm's picture

Hey guys.  Nice post Reggie.

I guess we must disagree about the notional stuff... I think there is a huge amount of double counting in there, because the big swinging dicks offset out of the money positions.  The beauty of a swap is due to how easy they are to deploy in this way.

I think based on the data we have, which is admittedly incomplete, net is more informative because it kicks out the double counting.  Such as it is.

A real problem with IRS is just like single name CDS... jump to default.  Bernanke plays his stupid game too far and you have a problem he can't print out of.  If LIBOR blows, then there will be less chance to reduce out of the money IRS exposure... nobody will take the other side of the trade.  But you know, if that happens, one's 401k is so irrelevant.

Irishmans Curse's picture

'many have even went so far as to call me “intelligent”.'