Is The Entire Global Banking Industry Carrying Naked, RISKY, Unhedged "Risk Free" Sovereign Debt? Quick Answer: Probably!

Reggie Middleton's picture

Summary: Since the king of Wall Street traders (not:The Squid That Can't Trade) carries so much risk free (not:Good 'Ole Lehman Collapse Days!)
sovereign debt heavily leveraged on their books, if it is proven that a
Greek default is not truly a default, hence not a credit event, then
isn't Goldman trading extreme risk naked and unhedged? Below, I delve
deeply into this question, looking for an answer!

This morning I saw the following from Nouriel Roubini on my twitter feed -Roubini Global Economics Paper: Are CDS Worthless Because Greece's Exchange Won't Trigger a Credit Event? http://bit.ly/ttrgFS followed by this from Chris Whalen - @Nouriel
Precisely. Fed, etc encourage CDS to generate income for TBTF banks,
then the banks welch on the bets by "investors" Kleptocracy
. As
anyone who follows me knows, I'm in lock step with that particular
opinion espoused by Chris. Still, the bigger and much more pertinent
question looms... Aren't the big US investment banks carrying trillions
of dollars of unhedged exposure? Quick answer: Hell Yeah!

Reality, Redux

First, a refesher on our European bank run theory expoused 5 months ago...

  1. Let's Walk The Path Of A Potential Pan-European Bank Run, Then Construct Trades To Profit From Such
  2. Greece Is Fulfilling Our Predictions Of Default Precisely As Predicted This Time Last Year
  3. The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!
  4. The Fuel Behind Institutional “Runs on the Bank” Burns Through Europe, Lehman-Style!

About a month ago, I posed the question When Does 3+5=4? When You Aggregate A Bunch Of Risky Banks & Then Pretend That You Didn't?
Condensed, Cliff Notes edition, Goldman has the most shortable share
price of all the big banks at around $100 and is quite liquid; it is
more susceptible to mo-mo traders than it is to it's own book value, it
is highly levered into the European debt/banking mess, and last but not
least, Goldman is the derivatives risk concentration leader of the world
- bar none! So, if anyone is in need of CDS as a good solid hedge, it
should be Goldman, no?

Click any and all graphics in this post to expand to print quality

Reggie_Middleton_hunting_the_Squid_Known_As_Goldman_Sachs_GS

The
need for strong hedges are quickly coming upon us, as well as for the
Squid. While everyone focuses on Greece, Italy's rates are skyrocketing
according to the FT: Greek woes send Italian yields to euro-era high

... Italian 10-year bond yields rose to 6.399 per cent, while the extra premium the country pays over Germany jumped to 459 basis points.

The
growing worries over Greece could undermine key government bond
auctions later on Thursday, with Spain due to sell a total of €4bn in
2-year and 4-year notes and France planning to raise €6bn-€7bn in 10-year and 15-year paper.

Italian yields and spreads over Germany are around levels at which the markets believe make the country’s debt payments unsustainable and could trigger extra margin payments for the use of Rome’s bonds as collateral.

Markets consider yields
of 6.5 per cent unsustainable on 10-year debt, while spreads above 450
basis points over Bunds have in the past prompted clearing houses to
charge extra margin payments for Ireland and Portugal.

LCH.Clearnet, for example, considers 450bp over a basket of triple A
countries a point at which extra fees may have to be charged.

In a further worrying sign, French borrowing costs rose, lifting the premium it pays over Germany to a fresh euro-era record of 135bp. Investors are increasingly worried that France could lose its triple A rating, which in turn would threaten the status of the European financial stability facility, the eurozone’s rescue fund.

...
Italian bonds have also been hit by the plan to use the EFSF to cover
first losses of new Italian debt which, some investors say, means that
there is little point in buying the country’s bonds ahead of such a
scheme being implemented.

The fact that the EFSF was forced to delay its own bond issue on
Wednesday has also hurt sentiment, as it calls into question not only
its ability to fund Ireland and Portugal but also its value as a
guarantor.

“The
abject failure of the new EFSF deal also confirms the European
nightmare is deepening, and should be a wake-up call to Europe’s elites
that their current efforts are going in the wrong direction and failing.
Failing dismally.”

Remember, these bonds are sitting on Goldman's books as "Risk Free Assets", leveraged to the hilt!

One more time, for the effect...

Italian yields and spreads over Germany are around levels at which the markets believe make the country’s debt payments unsustainable and could trigger extra margin payments for the use of Rome’s bonds as collateral.

Markets consider yields
of 6.5 per cent unsustainable on 10-year debt, while spreads above 450
basis points over Bunds have in the past prompted clearing houses to
charge extra margin payments for Ireland and Portugal.

LCH.Clearnet, for example, considers 450bp over a basket of triple A
countries a point at which extra fees may have to be charged.

In a further worrying sign, French borrowing costs rose, lifting the premium it pays over Germany to a fresh euro-era record of 135bp. Investors are increasingly worried that France could lose its triple A rating, which in turn would threaten the status of the European financial stability facility, the eurozone’s rescue fund.

 You see, in the post French Banks Can Set Off Contagion That Will Make Central Bankers Long For The Good 'Ole Lehman Collapse Days! I
explained that France's leveraged ties into Italy puts it at extreme
risk - much more risk than the market is currently pricing in. So, the
ball bounces from Greece, to Italy, to France... Hmmm, who's next? Well,
from the post Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?

As
we sit at the precipice of devastating European banking failure, upon
which Goldman is heavily levered into through excessive French exposure
(and you've seen how prescient our French banking analysis has been, bordering the prediction of the fall of Bear Stearns and Lehman),
I feel many of you should take heed when I say this bank's risk is
woefully underappreciated. As in the case of Bear, Lehman, Countrywide,
and a slew of other banks, the 10 minutes or so of your time to read
this heavy, fact filled piece could be worth a small fortune. While
we're at it, I would like to urge all paying BoomBustBlog subscribers  to (admiring the original artwork below, of course) to download and review the latest related documents on this topic:

    1. Goldmans Sachs Derivative Exposure: The Canary in the Coal Mine?
    2. Goldman Sachs Q3 Forensic Review - Retail or Professional levels
    3. Actionable Note on US Bank/ French Bank Run Contagion
  1. As the last few days have demonstrated, a ban run on US soil is still a distinct possibility, if not probability. Reference The Greco-Franco Bank Run Has Skipped the Pond and Landed in NYC.

What's
even more interesting is the fact that derivatives concentration and
counterparty risk is rampan in the US, while credit risk in Europe is
literally blowing up. What if CDS really are a faux hedge as I and other
astute (read objective) observers have come to realize? ReferenceThe Banks Have Volunteered (at Gunpoint)…

... let's peruse an email I received from one of my many astute BoomBustBloggers.

I'm
a lawyer (and investor). There is no analysis by anyone on the internet
about whether the announcement last night would in fact trigger CDS
payout. Rather, everyone seems to be accepting the claim by ISDA that
the decision would not trigger it. Because I can't find any legal
analysis worth reading on the internet I decided to do my own research.
In about 5 minutes I found a case in the 2nd Circuit (USA) that
explained to me what's going on with those contracts. First of all, they
are unregulated private contracts between private parties. In order to
know whether a trigger occurred you have to read each individual
contract. As a result, what the ISDA says about whether a trigger
occurred as to private contracts that are out there is totally
meaningless.

There
is merit to this assertion since the ISDA contract is simply a
non-binding template, often marked up to accommodate financial
engineering widgets designed to increase profit margin and decrease
transparency to clients and counterparties. By the time all of the
widgets are installed on some of these highly customized deals, the
original ISDA template is a non-issue.

What
seems to be the issue is whether there is considered to be "economic
coercion" going on if one of the events to trigger is "restructuring." 

Whaaattt!!! Coercion? What Coercion???!!! robbery_gun_1

 Furthermore,
you have to not look at voluntariness in a vacuum but compare the
(Greek) bond with the substitute being offered by EU to determine if
economic coercion or true voluntariness exists. For example, if the EU
will give priority in payment to the substitute it is offering and not
the original bond, that is the proper analysis in determining economic
coercion/voluntariness etc. My analysis here is based upon a very brief
reading of the case and I would need time to analysis fully. Also I'm
not a financial professional I don't understand all the implications of
what the EU announced. The reason I'm contacting you is because I
believe that in the coming days/weeks we will hear of entities that are
buyers of the CDS protection giving notice of a credit event to their
counterparties to seek to collect on the CDS contract. If payouts aren't made lawsuits will be filed. 

You
had better believe it. I really don't know why everybody is glazing
over this very obvious fact! Imagine if you bought protection on a bond
you acquired at par and you are offered 50% of it back (NPV) to be
considered whole while the CDS writer laughs at and says thanks for the
premiums... You'd probably break your fingers dialing your lawyer - out
of both the swap payments, the CDS payout, and 50% of your investment
that you thought (but really should have known better) was protected!

I
don't know what a US Court will decide as to whether a trigger has
occurred but there is a 2nd circuit case (the one I mentioned above)
that is the best I've found to give an inkling about this... I'm telling
you all this, because if I am right and there are claims that CDS was
triggered and CDS in fact gets triggered... [it should be made] public
so people start analyzing whether CDS was in fact triggered instead of
blindly accepting the drivel out of Europe that no trigger will occur.
That claim is obviously all about perception management not necessarily
truth.

So, is Goldman et. al. hedged are is it not? ZeroHedge dutifully reported that Five Banks Account For 96% Of The $250 Trillion In Outstanding US Derivative Exposure- a very interesting refresh of what I called out two years ago through "The Next Step in the Bank Implosion Cycle???":

The
amount of bubbliciousness, overvaluation and risk in the market is
outrageous, particularly considering the fact that we haven't even come
close to deflating the bubble from earlier this year and last year! Even
more alarming is some of the largest banks in the world, and some of
the most respected (and disrespected) banks are heavily leveraged into
this trade one way or the other. The alleged swap hedges that these guys
allegedly have will be put to the test, and put to the test relatively
soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk... ),
you cannot truly hedge multi-billion risks in a closed circle of only 4
counterparties, all of whom are in the same businesses taking the same
risks.

Click to expand!

bank_ficc_derivative_trading.png

This concept was further illustrated in An Independent Look into JP Morgan...

Click graph to enlarge (there is a typo in the graphic - billion should trillion)

image001.png

Here's
the question du jour - Can Goldmans Sachs Derivative Exposure,
realistically unhedged, cause the biggest run on the bank in Financial
History?

As excerpted from Hunting the Squid, Part2: Since When Is Enough Derivative Exposure To Blow Up The World Something To Be Ignored?

The notional amount of derivatives held by insured U.S. commercial banks have increased at a CAGR of 22% since 2005, which naturally begs the question
“Has the value or the economic quantity of the underlying increased at a
similar pace, and if not does this indicate that everyone on the street
has doubled and tripled up their ‘bets’ on the SAME HORSE?”

Think about what happens if (or more aptly put, "when") that horse loses! Would there be anybody around to pay up?

Sequentially, the derivatives have increased every quarter since Q1-05 except for Q4-07, Q3-08 (Lehman crisis) and Q4-10 while on a YoY basis the growth has been positive throughout recorded history.  In Q2-2011, the notional value of derivative contracts increased 2% sequentially to $249 trillion. The notional value of derivatives was 12% higher than a year ago.
The notional amount of a derivative contract is a reference amount from
which contractual payments will be derived, but it is generally not an
amount at risk. However, the changes in notional volumes can provide
insight into potential revenue, and operational issues and potentially
the contagion risk that banks and financial institutions poses to the
wider economy – particularly in the form of counterparty risk delta. The
top four banks with the most derivatives activity hold 94% of all
derivatives, while the largest 25 banks account for nearly 100% of all
contracts
.  Overall, the US banks derivative exposure is $249 trillion and is more than four folds of World’s GDP at $58 trillion.

In
absolute terms, JPM leads this list with total notional value of
derivative contracts at $78 trillion, or 1.3x times the Wolds GDP.
However, in relative terms, Goldman Sachs leads the list with
total value of notional derivatives at 537 times is total assets
compared with 44x for JPM, 46x for Citi and 23x for US Banks (average).

So,
what does this mean? Well, it should be assumed that Goldman is well
hedged for its exposure, at least on academic basis. The problem is its
academic. AIG has taught as that bilateral netting is tantamount to
bullshit at this level without government bailout intervention. If there
is any entity at risk of counterparty default or who is at the behest
of a government bailout if the proverbial feces hits the fan blades…
Ladies and gentlemen, that entity would be known as Goldman Sachs.

As excerpted from Goldmans Sachs Derivative Exposure: The Squid in the Coal Mine?, pages 2 and 3...

GS__Banks_Derivatives_exposure_temp_work_Page_2

Goldman
is much more highly leveraged into the derivatives trade than ANY and
ALL of its peers as to actually be difficult to chart. That stalk
representing Goldman's risk relative to EVERY OTHER banks is damn near
phallic in stature!

GS__Banks_Derivatives_exposure_temp_work_Page_3

As opined earlier through the links "The Next Step in the Bank Implosion Cycle???"and As the markets climb on top of one big, incestuous pool of concentrated risk... ,
this is not a new phenomenon. Quite to the contrary, it has been a
constant trend through the bubble, and amazingly enough even through the
crash as banks have actually ratcheted up risk and assets in a blind
race to become TBTF (to big to fail), under the auspices of the
regulatory capture (see Lehman Dies While Getting Away With Murder: Introducing Regulatory Capture).
So, what is the logical conclusion? More phallic looking charts of
blatant, unbridled, and from a realistic perspective, unhedged RISK
starring none other than Goldman Sachs...

 image006

And
to think, many thought that JPM exposure vs World GDP chart was
provocative. I query thee, exactly how will GS put a real workable
hedge, a counterparty risk mitigating prophylactic if you will, over
that big green stalk that is representative of Total Credit Exposure to
Risk Based Capital? Short answer, Goldman may very well be to big for a
counterparty condom. If that's truly the case, all of you pretty, brand name Goldman counterparties
out there (and yes, there are a lot of y'all - GS really gets around),
expect to get burned at the culmination of that French banking party
I've been talking about for the last few quarters. Oh yeah, that
perpetually printing clinic also known as the Federal Reserve just might
be running a little low on that cheap liquidity antibiotic... Just
giving y'all a heads up ahead of time...

image009

Do
you remember France? That country that no on is really paying attention
to, but whose exposure and risk is so systemic that it can literally
and unilaterally blow up the entire European continent? I post again,
for effect...

In a further worrying sign, French borrowing costs rose, lifting the premium it pays over Germany to a fresh euro-era record of 135bp. Investors are increasingly worried that France could lose its triple A rating, which in turn would threaten the status of the European financial stability facility, the eurozone’s rescue fund.

As
you read exactly how precarious the situation is in France (and
Belgium, through Dexia, et. al.) keep in mind that although this is
definitely not good news for Goldman's numbers, historically since the
beginning of this crisis, GS has actually correlated more with coke
laced, red bull juice powered mo-mo trader patterns than actual book
value - reference
The Squid Is A Federally (Tax Payer) Insured Hedge Fund Paying Fat
Bonuses That Can't Trade In Volatile Markets? Who's Gonna Tell The
Shareholders and Tax Payer???
from just last reporting period...

...
I'd like to announce to the release of a blockbuster document
describing the true nature of Goldman Sachs, a description that you will
find no where else. It's chocked full of many interesting tidbits, and
for those who found "The French Government Creates A Bank Run? Here I Prove A Run On A French Bank Is Justified And Likely" to be an interesting read, you're gonna just love this! Subscribers can access the document here:

As is customary, I have included these free samples for those who don't subscribe, so you can get a taste of the forensic flavor.

Discuss Finance, Investment, Blogs, Global Macro and Research with Reggie Middleton of BoomBustBlog at Salon de Ning

 700 Fifth Avenue  New York, NY 10019

6:45 pm, Friday November 4th

I will bring plenty of research, debate and discussion, so put your smart
caps on, be prepared to overpay for drinks and be in the company of
the beautiful women of NYC.

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