The day before yesterday I posted Who Will Be The Next JPM? Simply Review The BoomBustBlog Archives For The Answer. It was actually a very, very instructional post for although I run a subscription research service, there are troves of extremely insightful information buried in the archives - much of it available for free. It is actually ironic that one could have used the actual paid product to have predicted the events of this year with unerring accuracy two years ago, and using much of the same names from the 2008/9 archives profited heavily from the financial names that gave up 20% of the last few weeks. The more things change, the more they remain the same, eh? Which brings us to one of the first big warnings published on BoomBustBlog way back on Thursday, 08 May 2008:Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
Creation of colossal US$45 trillion CDS market may unfold into trouble larger than that of the subprime (really to be read as imprudent underwriting) crisis
The creation of the massive US$45 trillion CDS market in the last few years, which faces some unique problems, can unfold into a massive bubble collapse that would easily dwarf that of the subprime crisis. The CDS are supposed to cover the losses of banks and bondholders in the event of default by companies. However, the CDS market has evolved from being primarily a means to hedge credit risk to a speculative and trading platform for a large number of banks and hedge funds. If the corporate defaults surge in the coming quarters (as Reggie Middleton, LLC expects them to) or there is default in payments of coupon and principal amounts, this could lead to a crisis far worse than what we have seen so far in the current “asset securitization crisis” and quite possibly in the recent history of the financial system. The high yield default rate has increased significantly (125%) in the last few quarters from 0.4% in 1Q 07 to almost 0.9% in 1Q 08. In addition, the monolines which are under considerable stress and play the role of both counterparty as well as the reference entity in the CDS market could spell major trouble for the market participants.
Spectacular growth of credit risk transfer instruments
Fastforward five full years, and has anybody learned there lesson? Well, prance through the recent BoomBustBlog headlines to find the answer:
- Is The Entire Global Banking Industry Carrying Naked, Unhedged "Risk Free" Sovereign Debt Yielding 100-200%? Quick Answer: Probably!
If you don't trust the thoroughly researched, high end alternative info sources such as BoomBustBlog, realize that today Bloomberg reports U.S. Banks Sold More Insurance on Europe Debt, as annotated and excerpted:
Well you can't say they didn't see this coming, for I warned throughout 2010 via the Pan-European sovereign debt crisis series.
Guarantees provided by U.S. lenders on government, bank and corporate debt in those countries rose 10 percent from the previous quarter to $567 billion, according to the most recent data from the Bank for International Settlements. Those guarantees refer to credit-default swaps written on bonds.
JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc., two of the top CDS underwriters in the U.S., say they have bought more protection than they sold, indicating they may benefit from defaults in the region. That outcome is called into question by JPMorgan’s $2 billion loss on similar derivatives, which shows that risks don’t vanish when offsetting bets are taken, said Craig Pirrong, a finance professor at the University of Houston. “All these hedges trade one risk for another,” said Pirrong, whose research focuses on derivatives markets.
EXACTLY!!!!Risk doesn't disappear when you buy a hedge, it's simply shifted and transformed. In the case of the aforementioned 2008 article and my ramblings about the banks and insurers, naked credit (and market, depending on how the hedge was constructed) risk was simply traded for counterparty risk. With 96% of notional derivative exposure concentrated in just 6 banks - all with excessive leverage, opaque VouDou accounting (Sak Passe'), and tummy full of hidden NPAs amongst one of the worst macro environments of several lifetimes , one must question, "Is the counterparty risk one just assumed greater than the credit/market risk sold, combined?"
“The banks say they’re flat on European risk, but that’s based on aggregated positions. We don’t know how those will hold offif the European crisis blows up.”
JPMorgan Chairman and Chief Executive Officer Jamie Dimon said last week that the bank was trying to reposition a portfolio of corporate credit derivatives and used a flawed trading strategy. The lender, the largest in the U.S. by assets, is believed to have sold protection on an index of corporate debt and bought protection on the same index to hedge its initial bet, according to market participants who asked not to be identified because their trading strategies aren’t public.
The two bets moved in opposite directions this year, causing losses and proving that even hedges that look perfect can break down, Pirrong said.
Once again for the unitiated, shall we?
Reggie Middleton on CNBC's Squawk on the Street - 10/19/2010
Mr. Middleton discusses JP Morgan, bank risk and technology and is the only pundit in the financial media that we know of that called Apple's margin compression issues and did so successfully just hours before they reported! Click here or click below to see the video.
Here's a subscription dump of our archives for JPM to placate the insatiable thirst of the BoomBustBlog paid subscriber:
JPM Report (092209) Final - Professional09/24/2009
For those who have not read my seminal piece on Dimon's house of Morgan, JPM Public Excerpt of Forensic Analysis Subscription published nearly three years ago, allow me to take the liberty to excerpt it for you...
JPMorgan, Goldman Sachs
JPMorgan said in a regulatory filing that it purchased $144 billion of CDS related to the five European countries as of the end of the first quarter, while it sold $142 billion. Goldman Sachs (GS) bought $175 billion of protection and sold $164 billion, the firm said in its filing.... Bank of America Corp., Morgan Stanley (MS) and Citigroup Inc. (C) report only net CDS exposures. The five banks together account for 96 percent of the credit-derivatives market in the U.S., according to the Office of the Comptroller of the Currency. JPMorgan has written a quarter of the total, the OCC data show.
And here's the BoomBustBlog version of events:
|I'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & Introduction||
Summary: This is the first in a series of articles to be released this weekend concerning Goldman Sachs, the Squid! In this introduction (for those who do not regularly follow me) I demonstrate how the market, the sell side, and most investors are missing one of the biggest bastions of risk in the US investment banking industry. I will also...
|Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?||
Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?
Welcome to part two of my series on Hunting the Squid, the overvaluation and under-appreciation of the risks that is Goldman Sachs. Since this highly analytical, but poignant diatribe covers a lot of material, it's imperative that those who have not done so review part 1 of this series, I'm Hunting Big Game Today:The Squid On The Spear Tip, Part...
|Reggie Middleton Serves Up Fried Calamari From Raw Squid: Goldman Sachs and Market Perception of Real Risks!||
For those who don't subscribe to BoomBustblog, or haven't read I'm Hunting Big Game Today:The Squid On The Spear Tip, Part 1 & Introduction and Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?, not only have you missed out on some unique artwork, you've potentially missed out on 300%...
|Hunting the Squid, part 4: So, What Else Can Go Wrong With The Squid? Plenty!!!||
Yes, this more of the hardest hitting investment banking research available focusing on Goldman Sachs (the Squid), but before you go on, be sure you have read parts 1.2. and 3: I'm Hunting Big Game Today:The Squid On A Spear Tip, Part 1 & Introduction Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To...
Not all protection sold by banks is matched exactly by protection bought. CDS purchased and sold on Spanish sovereign debt can have different expiration dates. Banks also can net a swap on a Spanish bank with one on another lender. Even if those two firms are in a similar condition at the time of the trades, one could deteriorate faster, increasing the cost of CDS.
Some of the swaps sold by U.S. banks were bought by European lenders trying to reduce exposure to the five so-called peripheral countries. Since it’s considered insurance, a German bank can subtract the value of the contracts it purchased on Spanish debt from the total value of its holdings, with the understanding that if Spain doesn’t make good on its payment, the CDS underwriter will pay instead.
British, German and French banks’ loans to the five countries were reduced by 5 percent in the fourth quarter to $1.33 trillion, according to the BIS data. That was a $73 million decrease compared with the $53 million increase in U.S. banks’ CDS exposure to the periphery.
... Bank Losses
More than half of the CDS related to Spain, Italy and Portugal were to protect defaults by companies in those countries, not the government, according to data compiled by the Depository Trust and Clearing Corp., which runs a central registry for over-the-counter derivatives. About a quarter of the total in each country was protection on bank debt.
As banks in the five countries face mounting losses and funding strains, it’s impossible to model accurately how the risk on different institutions will change, Rowady said. Government and central bank interventions in markets can also upset correlations in those models, he said.
Now, I wouldn't go so far to say that it's impossible. After all, we did it and BoomBustBlog subscribers benefitted from it. Reference The BoomBustBlog Contagion Model: How We Predicted 9 Months Ago That The UK and Sweden Would Rush To Bail Out Ireland, and Why and Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!.
The BoomBustBlog Sovereign Contagion Model
Nearly every MSM analysts roundup attempts to speculate on who may be next in the contagion. We believe we can provide the road map, and to date we have been quite accurate. Most analysis looks at gross claims between countries, which of course can be very illuminating, but also tends to leave out many salient points and important risks/exposures.
In order to derive more meaningful conclusions about the risk emanating from the cross border exposures, it is essential to closely scrutinize the geographical break down of the total exposure as well as the level of risk surrounding each component. We have therefore developed a Sovereign Contagion model which aims to quantify the amount of risk weighted foreign claims and contingent exposure for major developed countries including major European countries, the US, Japan and Asia major.
I. Summary of the methodology
- We have followed a bottom-up approach wherein we have first identified the countries/regions with high financial risk either owing to rising sovereign risk (ballooning government debt and fiscal deficit) or structural issues including remnants from the asset bubble collapse, declining GDP, rising unemployment, current account deficits, etc. For the purpose of our analysis, we have selected PIIGS, CEE, Middle East (UAE and Kuwait), China and closely related countries (Korea and Malaysia), the US and UK as the trigger points of the financial risk dissemination across the analysed developed countries.
- In order to quantify the financial risk emanating in the selected regions (trigger points), we looked into the probability of the risk event happening due to three factors - a) government default b) private sector default c) social unrest. The probabilities for each factor were arrived on the basis of a number of variables determining the relative weakness of the country. The aggregate risk event probability for each country (trigger point) is the average of the risk event probability due to the three factors.
- Foreign claims of the developed countries against the trigger point countries were taken as the relevant exposure The exposures of each developed country were expressed as % of its respective GDP in order to build a relative scale for inter-country comparison.
- The risk event probability of the trigger point countries was multiplied by the respective exposure of the developed countries to arrive at the total risk weighted exposure of each developed country.
- Sovereign Contagion Model - Retail - contains introduction, methodology summary, and findings
- Sovereign Contagion Model - Pro & Institutional - contains all of the above as well as a very detailed methodology map that explains what went into the model across dozens of countries.
Latest Pan-European Sovereign Risk Non-bank Subscription Research
- Ireland public finances projections_040710
- Spain public finances projections_033010
- UK Public Finances March 2010
- Italy public finances projection
- Greece Public Finances Projections
Back to Bloomberg...
Last week, Spain’s government took control of Bankia SA (BKIA), the country’s third-largest lender, and asked banks to increase provisions for souring real estate loans. Losses of Spanish banks could top 380 billion euros, according to the Centre for European Policy Studies. Moody’s Investors Service downgraded the credit ratings of 16 Spanish banks yesterday and 26 Italian lenders earlier this week.
Oh yeah, we caught Spain too - as far back as 2008/9/10. Yes, the Spain pain was apparent 4 years ago. Follow the BoomBustBlog archives, starting with a post from this month The Spain Pain Will Not Wane: Continuing the Contagion Saga and going back to '09 - The Spanish Inquisition is About to Begin... and even farther back to '08 - Reggie Middleton on the New Global Macro - the Forensic Analysis of a Spanish Bank. Back to the Bloomberg article...
Counterparty failure is another risk for banks selling insurance on the debt of the five counties. When a swap is triggered by default, a bank could find that a client who sold the protection can’t pay. The firm still has to make good on its promise to pay whoever bought protection.
Lenders try to mitigate this risk by asking for collateral from their counterparties as the value of CDS or other derivative changes. Dexia SA (DEXB) failed in October when the bank faced 47 billion euros of such margin calls on interest-rate swaps it sold. If Dexia hadn’t been bailed out by Belgium and France, it wouldn’t have been able to put up the collateral, causing losses for its unidentified counterparties.
U.S. banks didn’t suffer losses when swaps on Greek sovereign debt were paid out in March because prices of CDS had surged and collateral was collected in advance, according to Francis Longstaff, a finance professor at the University of California Los Angeles. While collateral protects middlemen from counterparty risk, there could be unexpected losses if the price of CDS doesn’t rise to reflect an imminent default, he said.
“Sudden defaults would shock the market because then you wouldn’t have the collateral to cover the full payment,” Longstaff said.
Banks also may discover that collateral they hold might not be worth as much, said University of Houston’s Pirrong. That happened in 2008 when banks saw the value of mortgage-related securities held as collateral plummet.
“Collateral is a great way to protect yourself,” Pirrong said. “But when the financial system is in a crisis, you might end up holding an empty bag.”
All of the afore-linked articles and info should lead one to do as I did, and query Is The Entire Global Banking Industry Carrying Naked, Unhedged "Risk Free" Sovereign Debt Yielding 100-200%? Quick Answer: Probably! Of course, I could always be more direct and simply state, Squids, Morgans & Counterparty Risk: Blowing Up The World One Tentacle At A Time. Honestly, though, how is it that so few banks (five or six) can attain and allegedly hedge hundreds of trillions of dollars of exposure, yet assert they only have billions of dollars of risk? Asked in a more laymen, ex. common sense fashion, So, When Does 3+5=4? When You Aggregate A Bunch Of Risky Banks & Then Pretend That You Didn't?
Here's a list of archives to browse through for those very few who actually give a damn...
- Listen Carefully and You Can Hear the Crumbling Of The Sovereign Nation Formerly Known As JP Morgan
- A Few Quick Comments On Goldman's Q4 2011 Results
- CNBC Favorite Dick Bove Admits To Being Wrong On Banks, But For The Right Reasons, But Those Reasons Are Still Wrong!!!
- Yes, The BoomBustBlog Forecast Pan-European Bank Run Has Breached American Soil!!!
- What Was That I Heard About Squids Raising Capital Because They Can't Trade?
- BNP, the Fastest Running Bank In Europe? Banque BNP Exécuter
- Reggie Middleton vs the Squid That Can't Trade!
- The Greco-Franco Bank Run Has Skipped the Pond, Landed in NY/Chicago and Nobody Noticed, Exactly As I Predicted!
- The Ironic, Prophetic Nature of the MF Global Bankruptcy Filing and It's Potential Ramifications
- On Challenges To The Mainstream Financial Channels, BofA's (In)Solvency and Long-Only Pundits Dominating the MSM
- The Street's Most Intellectually Aggressive Analysis: We've Found What Bank of America Hid In Your Bank Account!