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

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

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

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

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

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

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

Dear Reggie

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

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

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

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

Anyway, its been game over already for many banks:

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

      Cute graphic above, eh? There is plenty of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don't we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman ("Is Lehman really a lemming in disguise?": On February 20th, 2008) months before their collapse by taking a close, unbiased look at their balance sheet. Both of these companies were rated investment grade at the time, just like "you know who". Now, I am not saying JPM is about to collapse, since it is one of the anointed ones chosen by the government and guaranteed not to fail - unlike Bear Stearns and Lehman Brothers, and it is (after all) investment grade rated. Who would you put your faith in, the big ratings agencies or your favorite blogger? Then again, if it acts like a duck, walks like a duck, and quacks like a duck, is it a chicken??? I'll leave the rest up for my readers to decide.

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

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

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

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

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

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

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

Reggie vs Goldman Sachs

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

Please click the graph to enlarge to print quality size.


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

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

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




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





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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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