Early in 2008 I named Morgan Stanley the "The Riskiest Bank on the Street" (see historical links at the bottom of this article). Well, now its time to update my opinion. Who deserves the title "The Riskiest Bank on the Street" now? Well, let's see what the market says...

As defined by Wikipedia: Cost of Captial - Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.

This means that one should not simply glance at accounting earnings and declare all is clear on the western front. Whatever return your company generates has to exceed the cost of investing in said company. Well, of the bulge bracket, who has the highest cost of capital? Who has the highest bar? Who does the Street see as the Riskiest Bank on the Street?


Well it seems as if the company that had the highest cost of capital apparently had enough risk to actually implode. Is there a pattern here? If so, I must be the only one that recognizes it because the current number one spot (the graphed number one spot already collapsed) traded over $130 per share last week.

For those that don't believe in Cost of Capital in measuring risk, I bring you to another metric. As defined by Wikipedia: Leverage (or gearing due to its analogy with a gearbox) is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced.[1] It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. Deleveraging is the action of reducing borrowings.[1]

Financial leverage

Financial leverage (FL) takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets (ROA) is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow because assets = equity + debt (see accounting equation). On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor that otherwise would have been unavailable but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying is a common way of utilizing the concept of leverage in investing. An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firm is made up of ownership equity and debt. A firm's debt to equity ratio is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem. As is true of operating leverage, the degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (earnings per share) that occurs as a result of a percentage change in earnings before interest and taxes.


Goldman Sachs Stress Test Retail Goldman Sachs Stress Test Retail 2009-04-20 10:08:06 720.25 Kb - 17 pages

Goldman Sachs Stress Test Professional Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb - 131 pages


Derivatives allow leverage without borrowing explicitly, though the "effect" of borrowing is implicit in the cost of the derivative.

  • Buying a futures contract magnifies your exposure with little money down.
  • Options do the same. The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument. Generally speaking, a put option allows the holder (owner), the investor, to achieve inverted-leverage and/or inverted enhancement--- sometimes called inverse enhancement and/or inverse leverage.
  • Structured products that exist as either closed-ended funds, or public companies, or income trusts are responding to the public's demand for yield by leveraging. That's a good idea. Let's refer to Goldman Sachs as a Structured Product!

Risk and overleverage

Employing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Interest and principal payments (usually certain ex-ante) may be higher than the investment returns (which are uncertain ex-ante).

This increased risk may still lead to the optimal outcome for the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and security purchases, is the subject of a discipline known as financial engineering.

There are economic periods when optimism incites to a widespread and excessive use of leverage, what is called overleverage. One of its forms, associated to the subprime crisis, was the practice of financing homes with no or little down payment, playing on the hope that the price of the assets (the property in this case) will rise. Another form involved the five largest U.S. investment banks, which borrowed funds to invest in mortgage-backed securities, increasing their leverage between 2003-2007 (see diagram). During September 2008, the five largest firms either went bankrupt (Lehman Brothers), were bought out by other banks (Merrill Lynch and Bear Stearns) or changed to commercial bank holding companies, subjecting themselves to leverage restrictions (Morgan Stanley and Goldman Sachs).

Well, on the topic of leverage, who do you think is the most leveraged bank? Notice that these leverage ratios below are unadjusted. That means that they will go up significantly if I took the time to extract the accounting shenanigan trash that is used to give the impression of lower leverage (this adjustment is explictly done in the 131 page Goldman Sachs Professional Stress Test).


Notice that although Goldman Sachs is the leveraged risk winner as of now, but they would have probably been beaten by Merrill Lynch. Hey, where is Merrill Lynch by the way? You know, it can get pretty painful for guys to play hide the "leveraged" sausage. If you know what I mean...

Okay, for you real stubborn guys and gals who don't think the cost of capital or leverage are legitmate determinants of risk, let's take a look at other popular risk metrics. Surely they will vindicate the riskiest bank on the Street, right? Below, please find the Goldman Sachs VaR and Risk Adjusted Return on Risk Adjusted Capital Chart.


Now, as we can plainly see, Goldman Sachs has steadily trended down in its RARORAC and steadily trended higher in VaR. In other words, risk has steadily increased as risk adjusted return has steadily decreased.

For those who feel I am simply blogging in sanscrit, let's pull up the Wikipedia definitions for VaR and RARORAC:

Value at Risk (VaR):

In financial mathematics and financial risk management, Value at Risk (VaR) is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.[1]

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds the VaR threshold is termed a “VaR break.”[2]

The 10% Value at Risk of a normally distributed portfolio

VaR has five main uses in finance: risk management, risk measurement, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well.[3]

Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust in the late 1970s. Note, however, that more and more Risk Adjusted Return on Risk Adjusted Capital (RARORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel II.


Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, that is it is a buffer against heavy shocks. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.

RAROC system allocates capital for 2 basic reasons:

  1. Risk management
  2. Performance evaluation

For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure—that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit.

Now that we're all up to speed, let's take this one step farther. Below you may find the One-Day Trading VaR of GS with a 95% confidence level.


Here we find proof that Goldman Sachs has indeed usurped Morgan Stanley for the title of "Riskiest Bank on the Street".


Hey, notice how Goldman Sachs has trended DOWNWARD regularly and steadily over the one year period. As a matter of fact, the only company that had a lower risk adjusted capital return was Lehman. So let's compare what is happening now... Oh yeah, we can't because Lehman has already collapsed. What does that portend for Goldman who appears to operate quite similarly?


I know many of you new readers are wondering, "Who the hell is this guy?". Well, this guy is someone who has been pretty good at ferreting out weak companies on the verge of collapse:

There is the call of the fall of REITs and commercial real estate in 2007 - "GGP has finally filed Bankruptcy, Proving My Analysis to be On Point Over the Course of 18 Months". I also called Bear Stearns (Is this the Breaking of the Bear? [Sunday, 27 January 2008]), Lehman Brothers CRE implosion connection (Is Lehman really a lemming in disguise? [Thursday, 21 February 2008]), Countrywide and Washington Mutual (Yeah, Countrywide is pretty bad, but it ain’t the only one at the subprime party… Comparing Countrywide with its peer), nearly all of the failed or failing regional banks of significant size (As I see it, these 32 banks and thrifts are in deep doo-doo!), MBIA (A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton) and Ambac (Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap and Follow up to the Ambac Analysis), among others - well in advance.

More Goldman Sach's Research:


Goldman Sachs Stress Test Retail Goldman Sachs Stress Test Retail 2009-04-20 10:08:06 720.25 Kb - 17 pages

Goldman Sachs Stress Test Professional Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb - 131 pages

Free research and opinion

§ As Reality hits, the Masters of the Universe are starting to look like regular bank employees

Premium Stuff!

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Historical context for the "Riskiest Bank on the Street" moniker.

Banks, Brokers, & Bullsh1+ part 1

Wednesday, 19 December 2007 | Reggie Middleton

A thorough forensic analysis of Goldman Sachs, Bear Stearns, Citigroup, Morgan Stanley, and Lehman Brothers has uncovered... Last week, Morgan Stanley called Citibank the “short play of...

The Riskiest Bank on the Street
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)

Key highlights of my research on the "Riskiest Investment Bank on the Street": The Riskiest Bank on Wall Street – Morgan Stanley has US$74 billion of Level 3 assets, over 200% of its eq
Monday, 11 February 2008

A closer look at the exposure of the other brokers
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)

...- Who has the most of their assets tied up in illiquid Level 3 as a proportion to tangible equity? You guessed it, The Riskiest Bank on the Street. Now, they do have a decent amount of liquidity the ...
Sunday, 16 March 2008

19. On the insolvencies of non-bank financial institutions
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
...Bullsh1+ part 1 Banks, Brokers, & Bullsh1+ part 2 Money Panic Bear Fight The Breaking of the Bear The Riskiest Bank on the Street Here comes the CRE Bust (Quip on Lehman Brothers)...
Tuesday, 18 March 2008

20. Quick Morgan Stanley update from my lab
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
This is a refresher to the The Riskiest Bank on the Street piece that I posted a few months ago on Morgan Stanley. Let me get straight to the salient points. High exposure to lev
Thursday, 20 March 2008

21. Early morning scan of events
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
For those that haven't noticed, I've begun sharing my early morning news and data routine with the blog. Here goes Monday moring EST. Is the Fed running out of ammo? Reserve
Monday, 31 March 2008

22. Reggie Middleton on the Street's Riskiest Bank - Update
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
This is the update to my forensic deep dive analysis of Morgan Stanley. It is still, in my opinion, the "riskiest bank on the street". A few things to make note of as you browse through my opinion a
Sunday, 06 April 2008

23. Banks, Brokers & Bullsh1t 3.0: Shenanigans at Morgan and Lehman
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
I've been promising to give an illustration of the shenanigans being played by the commercial and investment bank's for some time now, but I've been quite busy working on my entrepeneurial pursuits
Wednesday, 16 April 2008

24. I warned you about the risk of those I Banks
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
...ive counterparty and credit risk to imperfect hedges to dead and depreciating assets held off balance sheet: The Riskiest Bank on the Street Is this the Breaking of the Bear? Banks, Broke...
Wednesday, 21 May 2008
Published in BoomBustBlog

I have reviewed analyses of the PPIP in blogs and news outlets across the web and have perused the comments section in as well. I am impressed by the bright, cogent analysis but need to warn my blog readers that those early analyses may not be based upon the facts as described in the actual plan but upon speculation as to what the plan may contain. I have had my team review the plan and we will reveal what it means to the analysis that we have released as well as what I foresee for the future. the historically ridiculous (as in one of the greatest rallies ever, based upon a plan that practically no one who participated in the rally has actually read cover to cover) is evidence of technical and momentum orientated traders and not a change in the fundamentals. I'm not saying that the fundamentals have not changed, but we need a chance to find out. I can say that price discovery needs to occur on a natural level for a sustainable bull market. To my knowledge, that has not happened and it is not a feature of the PPIP. I will explore the plan and its parameters in detail and report back ASAP! Obviously, this will be a topic for discussion at the BoomBustBlog event tonight (BoomBustBlog Networking - Trading Reggie's Research).

About the Program

The US sponsored Public-Private Investment Program intends to target legacy assets - legacy loans (real estate loans held "directly" on the books of banks) and legacy securities ("securities backed by loan portfolios").

The Aim of Program: A huge decline in prices of legacy assets have strained the capital of financial institutions limiting their ability to lend and have increased cost of credit. The stated goal of the Public-Private Investment Program is to strengthen capital base of financial institutions and enhance their ability to lend, ensure efficient price discovery of legacy assets by involving private players and minimizing the risk to taxpayers while providing opportunity to private players to earn sufficient returns.

Legacy Loan Program

The program intends to attract private capital to purchase eligible legacy loans from participating banks through the provision of FDIC debt guarantees and Treasury equity co-investment.

Financing: The private participants (individual investors, pension plans, insurance companies and other long-term investors) alongside Treasury will provide equity financing. The Treasury intends to provide 50% of the equity capital for each fund, but private managers will retain control of asset management subject to FDIC oversight (this is an interesting point). FDIC will provide a guarantee for debt financing issued by the Public-Private Investment Funds to fund asset purchases.


  • Banks would decide which assets (ex. a pool of loans) - they would like to sell.
  • The FDIC will then conduct an analysis to determine the amount of funding it is willing to guarantee, limiting the leverage to 6:1 (much of the analysis that I have read assumed a foregone conclusion of 6:1 leverage).
  • The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50% of the equity requirement of their purchase.
  • If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.
  • The Treasury would then provide 50% of the equity funding
  • The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis - using asset managers approved and subject to oversight by the FDIC.
  • Private sector investors would stand to lose their entire equity investment in a downside scenario.

Legacy Securities Program (securities tied to residential & commercial real estate and consumer credit).

The goal of this program is to restart the market for legacy securities, allowing banks and other financial institutions to free up capital and stimulate credit flow. Price discovery will also reduce the uncertainty surrounding pricing of these legacy securities held by other financial institutions. My opinion is that this is not true price discovery, primarily due to the non-recourse nature of leverage implemented, which will engender considerably more reckless risk taking due to the warping of the naturally occurring risk/reward curve!


The Legacy Securities Program consists of two related parts to draw private capital.

o Providing debt financing from the Federal Reserve under the Term Asset-Backed Securities Loan Facility (TALF). Non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency RMBS that were "originally" rated AAA (read as distressed and most likely sloppily underwritten) and outstanding CMBS and ABS that "are" rated AAA. Duration of loans, lending rates and minimum loan size are yet to be determined.

o Match private capital being raised for dedicated funds targeting legacy securities. Treasury will approve up to five asset managers with a demonstrated track record of purchasing legacy assets who would be provided a time frame to raise capital and matching capital would be contributed by the Treasury. Asset managers could also subscribe for senior debt for the Public-Private Investment Fund from the Treasury Department in the amount of 50% (100% in certain cases) of total equity capital of the fund. Thus Manager could manage as far as $4 of assets for every dollar raised (max out at 4:1 leverage).

Our take on the plan

Private investors under Legacy Loan Program have huge downside risk: The position of private investors is similar to an equity tranche in a CDO. These private investors could enjoy huge upside returns on back of massive leverage as high as 13:1, (6:1 is the leverage for fund of which Treasury would contribute 50% of capital) but however they would be the 1st to bear the loss in the event of further losses. These further losses are imminent, in my (and our) view (see the real estate review in the following post).

The very fact that a bank is willing to sell its legacy assets at a discount underscores the potential risk inherent in those securities. We believe prudent institutional investors would be reluctant to be in an equity tranche position in such high risk securities.Then again, I have overestimated the prowess and prudence of institutional investors in the past.

Potential demand for distressed assets in a zero sum game: The success of the plan to a great extent depends upon risk appetite of plan participants towards distressed securities. Despite the fact that there are huge upside potential for these legacy assets, private investors' would have no methodology to determine what prices to bid for these securities since aggressive pricing to buy assets could significantly reduce returns and even result in losses since the underlying assets of these are plunging rapidly. On the contrary conservative price bidding could force massive wave of write-downs for other banks and financial institutions. This seems like zero-sum game where gains of financial institutions at private investors expense and vice-versa.

Willingness of banks to participate in the program and undertake mark-to-mark write downs

There is no incentive for banks to participate in the program unless and until they require immediate capital. Banks which have already taken huge write-downs (ex. the ex-investment banks) would be better off holding these assets until maturity. On other hand banks which have been conservative on their asset write-downs (ex., the Doo Doo 32) would be reluctant to sell their legacy assets under the plan because that would significantly increase the mark-downs.

Risk of overpayment for legacy assets

Guidelines: An independent valuation firm will provide valuation advice to inform the Legacy Loans Program in its bidder selection. Also as mentioned earlier PPIF leverage would be limited to 6:1 based upon analyses performed by the FDIC with input from a Third Party Valuation Firm

We believe that since the first loss is being borne by private investors there would be no incentive to overbid. The price determination is by auction process so market forces could enforce a better price stability than determined by Treasury alone.

Huge downside loss do not justify the potential risk: If one were to simply run the numbers in a simple spreadsheet, you will see that although there is the potential for significant upside, the risk is not trivial.

Sample Investment under the Legacy Loans Program

value of pool of mortgages
Price determined by auction 84.0 <--Be aware that the lower this number, the greater the
capital hit to the selling bank!
Debt-Equity ratio 6.0
Debt FDIC Guaranty 72.0
Equity by private investor 6.0
Equity by treasury 6.0
Interest on FDIC Debt 4.0%
Discount Face Value by X% 2.2%
$ Gian
Interest on FDIC debt Gain to equity investor Gain / loss to Private investor* % return
Actual Value
Face value $100.00 $16.00 $2.88 $13.12 $6.56 109.3 %
97.8% discount on FV $97.80 $13.80 $2.88 $10.92 $5.46 91.0 %
95.6% discount on FV $95.65 $11.65 $2.88 $8.77 $4.38 73.1 %
93.5% discount on FV $93.54 $9.54 $2.88 $6.66 $3.33 55.5 %
91.5% discount on FV $91.49 $7.49 $2.88 $4.61 $2.30 38.4 %
89.5% discount on FV $89.47 $5.47 $2.88 $2.59 $1.30 21.6 %
87.5% discount on FV $87.51 $3.51 $2.88 $0.63 $0.31 5.2 %
85.6% discount on FV $85.58 $1.58 $2.88 ($1.30) ($1.30) (21.7)%
83.7% discount on FV $83.70 ($0.30) $2.88 ($3.18) ($3.18) (53.0)%
81.9% discount on FV $81.86 ($2.14) $2.88 ($5.02) ($5.02) (83.7)%
80.1% discount on FV $80.06 ($3.94) $2.88 ($6.82) ($6.00) (100.0)%

*Assuming gains are shared on proportionate basis to investment

As seen in the table above the downside risk does not justify the risk undertaken by the prudent investor.The risk/reward profile here happens to be very similar to the equity tranches of the CDO's that blew up last year. We have seen many of those equity tranche investors take 100% losses. After taking an empirical look at the program, I now see why the non-recourse sweetener and excessive leverage had to be added, but the fact still remains that the existence of this highly favorable financing distorts price discovery. If it is an unfavorable risk/reward ratio with near free money that you don't have to pay back, just imagine what the natural pricing would look like without these extra-market incentives!!! For those who want to play with their own assumptions, simply register for a free membership at BoomBustBlog and download the model that created the table above -
pdf Quick and Clean Public Private Partnership Risk/Return Model 2009-03-24 09:57:27 57.50 Kb .

Potential Impact on Banks and Insurers

  • Plan could lead to considerable write-downs of assets particularly for those banks and financial institutions who have been conservative in their write-downs in case the securities price determined is considerably less than current valuations. This is most likely where Geithner is planing to plug in the stress testing and the forced capital injection program from the TARP. I believe that many of the insurers, asset managers and regional banks covered in BoomBustBlog have a ways to go in writing down their assets (see topics: Insurers and Insurance, Commercial Banks, and Financial Services).
  • According to estimates, banks are currently holding at least $2 trillion in troubled assets, mostly residential and commercial mortgages. If successful the plan could considerably help banks to transfer their toxic assets and free up their capital. The plan currently plans to buy $500 billion of assets with potential to increase to $1 trillion.

I will follow up on this tomorrow, with further analysis and opinion, and will continue with an update on real estate value trends (undoubtedly extremely negative). For all who do not realize, downward real estate price trends will considerably distress, further, the most of the assets at the base of the PPIP program.

For those who are not members of the BoomBustBlog, I have detailed this crisis from the beginning in what is now a 36 part series:

Recommended Global Macro Reading:

  1. China Macro Update
  2. Debt - Thoughts On A Global Problem (Part 1),

  3. Banking out of Control (Part 2)
  4. Global Debt Stats (Part 3)

Recommended Reading - The Asset Securitization Crisis:

  1. Intro:
    The great housing bull run - creation of asset bubble, Declining
    lending standards, lax underwriting activities increased the bubble - A
    comparison with the same during the S&L crisis
  2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
  3. Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. Municipal bond market and the securitization crisis - part I
  6. Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
  7. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
  8. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  9. More on the banking backdrop, we've never had so many loans!
  10. As I see it, these 32 banks and thrifts are in deep doo-doo!
  11. A little more on HELOCs, 2nd lien loans and rose colored glasses
  12. Will Countywide cause the next shoe to drop?
  13. Capital, Leverage and Loss in the Banking System
  14. Doo-Doo bank drill down, part 1 - Wells Fargo
  15. Doo-Doo Bank 32 drill down: Part 2 - Popular
  16. Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank
  17. The Anatomy of a Sick Bank!
  18. Doo Doo Bank 32 Drill Down 1.5: Wells Fargo Bank
  19. GE: The Uber Bank???
  20. Sun Trust Forensic Analysis
  21. Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street
  22. Goldman Sachs Forensic Analysis
  23. American Express: When the best of the best start with the shenanigans, what does that mean for the rest..
  24. Part one of three of my opinion of HSBC and the macro factors affecting it
  25. The Big Bank Bust
  26. Continued Deterioration in Global Lending, Government Intervention in Free Markets
  27. The Butterfly is released!
  28. Global Recession - an economic reality
  29. The Banking Backdrop for 2009
  30. Reggie Middleton on the Irish Macro Outlook
Published in BoomBustBlog

The high leverage, low cost loans provided to buy the dead assets from the resultant bubble stemming from offering high leverage, low cost loans (just a year or two ago) will create another bubble that is destined to pop. The optimal solution is to let this current bubble pop. It appears that the powers that be really don't want the bubble to pop and fully deflate. The problem is that bubbles cannot be inflated in perpetuity. I think that's why they call them bubbles!

Pray tell, what happens to the toxic assets prices after the private sector overbids for them using excessive, low cost government leverage (or collusion, which is possible when the bank can turn around and sell a swap to the buyer to cover losses on the miniscule equity at risk) when those purchasers then attempt to resell them to normal buyers who don't have access to 6:1, sub 2% leverage on a non-recourse basis (or the cooperation of the bank to cover their equity losses)? No banks or brokerages that I can think of are offering terms anywhere near this level. Will our government continue to play Global Prime Broker ad infinitum by supplying margin to everyone who asks for it, forever? Highly doubtful!

Well, just like with the subprime crisis, once reality hits the fan, and that cheap and easy credit is no longer available, asset prices will fall - and they will fall hard - just like they did last time. Just like they will do every time. It is the the nature of a bubble. They get popped! The market can rally all it wants on the news of this latest bailout, natural market price discovery has yet to take place, and when it does, downward pricing pressure will rear its ugly head again. Only this time, the assets will fall in price after the government would have spent $100 billion to $1 trillion to buy them, and eat up tax payer monies directly. Natural market price discovery is the endgame, and the only way the bear market turns to a real, full-fledged bull market. I can't give you timing on this, but I can give you the parameters.

Now, many may be saying that the assets are now off of the bank's books so they can resume doing business. Well, that statement first assumes that all banks will sell all of their assets at that optimal price. It also assumes that there is a lot of business to be doing. We still have too many banks crowding into the same markets for one, and most importantly in terms of lending, the only retail and corporate borrowers who are crowing for debt right now are the ones that shouldn't be lent to in the first place. Back to the bubbly days of giving people and companies credit that really shouldn't have it? How fleeting is YOUR memory? Think about it. If you are a very good risk and have the capital and resources to repay loans easily, have you thought about buying a new home lately? You have a lot of people who are in trouble trying to refinance, but then again they are in trouble aren't they? I don't see prudent banks rushing out to lend to them at attractive rates. The same goes for the corporate sector. There are a lot of GGPs out there who need loans, but who really wants to lend to them? They want to lend to Berkshire, who doesn't seem to be in the market for loans right now.

We also have the issue of what happens to the losses. No amount of chicanery, engineering or magic will eliminate losses. Losses are losses and they need to be taken. It appears as if an overbid for assets with losses embedded will simply transfer those losses to the winning bidder. If the winning bidder has a super sweet deal, with nearly no risk, financed by the tax payer, then the losses are transferred from the winning bidder to the tax payer. If there is no winning bidder, then the losses remain with the bank. If the bank and the bidder collude in hiding the losses through inflated prices that are made to look profitable, ex. Mega fund buys the assets from the bank at the Truth + X percent, then turns around and buys a swap from the bank paying off X percent +1 to cover their exposure (which in reality is a guaranteed loss), then things look hunky dory until the underlying assets and or the cash flows start breaking down. Then the losses become apparent somewhere, most likely to the detriment of the taxpayer.

You see, no matter which way you slice it, if there are substantial losses in the system it will surface somewhere and somehow - and there are substantial losses in the system. The market is rallying as if the losses have evaporated. This is a profit opportunity, but you will have to be able to swallow a lot of volatility (or be a lightning quick trader) and have a minimum 3 month to 1 year horizon. Even if the bank and the fund make it look all hunky dory, when the losses do surface and the tax payer ends up biting it, and it will be manifested in lower consumer expenditure due to lower discretionary income which will be felt directly and immediately by the banks and the banks biggest customers. Hence, the losses will come round robin.

My suggestion??? Let's stop playing these games and force those who created the losses to take them now and we can all get back to the business of being the world's pre-eminent global economic superpower. Otherwise, that title may very well be up for grabs.

I will have objective analysis of the most recent bailout plan and its potential upside and fall out very soon and will post it accordingly.

Published in BoomBustBlog

I would like to make it clear that MBIA and the other
monolines have assisted the investment, commercial and mortgage banking
industry in the significant inflating of the perception of capital available.
If (or more aptly, when) this charade comes to an end (apparently
imminently) the banking system will recieve another, quite significant
shock to the system. One of several very interesting emails that I
received over the weekend.


I am e-mailing about MBIA's recent restructuring announcement, which
involves the transfer of $5B out of MBIA Insurance Corporation to one
of its subsidiaries, MBIA Illinois (to be renamed). $2.9B of the $5B
was paid for MBIA Illinois to reinsure 100% of MBIA Insurance
Corporation's public finance exposures. The remaining $2.1B was
transferred via a return of capital to MBIA Inc., MBIA Insurance
Corporation's parent. Concurrent with the transfer, MBIA Insurance
Corporation's ownership interest in MBIA Illinois has been confiscated
and transferred to another MBIA subsidiary. On the surface, this
wreaks of blatant theft and fraud.

Published in BoomBustBlog
Tuesday, 16 December 2008 23:00

Better 5 or 6 months late, than never

GE in the MSM (mainstream media):

S&P Says GE's Credit Rating May Be at Risk
Wall Street Journal - 1 hour ago
Credit analyst Robert Schulz warned earnings and cash flow at GE Capital could decline enough over the next two years to warrant a downgrade, ...
GE, GE Capital Ratings Outlook Cut to Negative by S&P Bloomberg
S&P says chance GE could lose AAA rating Forbes
Stocks Slip After GE's Outlook Lowered Briefing.com

GE in my blog, 6 months ago:

GE and the Uber Bank Forensic Analysis
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
This is the follow up to the preview of our analysis of GE. A PDF version is here: GE_ResearchReport_04July2008 (163.44 kB 2008-07-09 13:50:44). These are drafts and haven't received a fi
Wednesday, 09 July 2008

GE: The Uber Bank???
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
I'm taking a closer look at GE, the industrial cum uber bank bellweather of the Fortune 500. See the following draft overview, to be followed up by a full forensic analysis. I apologiz, for I've h
Monday, 16 June 2008

Come on MSM guys. Some of you guys really need to get at me. Imagine what a boombustblog.com powered financial section would look like in Forbes, Fortune or Barron's.Here's the model for those who haven't seen it.

Published in BoomBustBlog
Sunday, 23 November 2008 01:00

The Giants of Wall Street

Excerpted from From the NY Daily News:

Giants claim defunct firm Lehman Brothers owes team $300M

Big Blue claims the bankrupt investment behemoth owes the team $301.8 million from a complex financing deal for its new stadium in the Meadowlands.

The battle centers on a high-risk financial contract - the kind that has contributed to America's economic meltdown - between football's reigning champs and Wall Street's leading chumps.

It surfaced in a little-noticed, 238-page claim Giants co-owner John Mara filed in federal Bankruptcy Court on Oct. 17. It contends the team was guaranteed full payment because Lehman defaulted on its obligations.

The team filed a second claim to collect another $401,500 from Lehman to cover half of its $803,000-a-year bill for leasing an on-the-sidelines luxury suite with a bar and space for 24 guests, bankruptcy filings show. A stadium spokeswoman said the luxury suite issue had been "resolved." She refused to provide dThe Giants could also hire 38 wide receivers at Plaxico Burress' $7.85 million salary for Manning to throw the ball to.etails...

... "It would be quite unhealthy to hold your breath waiting for the Giants to get paid," said Reggie Middleton, who runs the Boom Bust Blog and was one of the earliest investors to warn of Lehman's impending demise. "They can expect to recover less than 9 cents on the dollar - a lot less - and they'll probably get zilch."

The Giants have a long wait before they can collect. "It could be as long as three or four years," said Lynn LoPucki, a law professor at both Harvard and UCLA and an expert on corporate bankruptcies. "Widows and orphans might qualify for a hardship claim and get paid earlier, but the New York Giants are an unsecured creditor - and they won't be on anybody's list to get paid ahead of schedule."

The flashpoint is the 82,500-seat, open-air new Meadowlands Stadium the Giants and Jets have been jointly building since 2007 on a 40-acre site across the Hudson.Complete with four restaurants, a Hall of Fame, 213 luxury suites, 2,000 video screens and a 300,000-square-foot outdoor plaza for tailgate parties, the stadium, expected to open in the spring of 2010, is budgeted at $1.6 billion.

To fund it, the National Football League loaned the teams $150 million apiece in 2007. The Giants and Jets each snared $650 million bank financing deals, with the Giants buying 40-year bonds from a seemingly healthy Lehman Brothers. Interest on those bonds, paid out until 2047, could be punishing, and the Giants wanted to reduce borrowing costs.

So they entered into a so-called interest rate swap with Lehman, "swapping" interest that could float much higher for fixed interest that would remain moderately priced, court filings indicate...

..."The agreement broke down the day Lehman declared bankruptcy" on Sept. 15, said Middleton, who analyzed the deal at the request of The News. The Giants were suddenly at risk of having to pay over time all the borrowing costs they had expected to save - an amount calculated at $301.8 million - because Lehman defaulted.


I have been crowing about investment bank and commercial bank insolvency for over a year now.

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?. We all know how both of these stories ended. Please click the graph to enlarge to print quality size.


If I am not mistaken, didn't the major rating's agencies have an investment grade rating on Lehman leading up into its bankruptcy? What a damn shame.

Published in BoomBustBlog
Thursday, 16 October 2008 02:00

Do you who's going to screw who next week?

spent the majority of my Wednesday spreading my bearish positions
further around the European banks (the balance was catering to my beautiful, yet demanding 2 year old daughter). Let me give you a glimpse into some of the
reasons why. First a glance at the home page of Bloomberg.com yields...

1. U.S. Stocks Plunge Most Since Market Crash of 1987 on
Recession Concerns-
Sounds like a market crashing to me.

VIX Index of U.S. Options `Exploding' Amid Growing Concerns
About Economy-
Hey doesn't this hypervolatility almost always precede a major market crash?

Bernanke Says Fed May Take New Role in Trying to Curb
Asset-Price Bubbles
- Which
contradicts the story below. If you want to prick asset bubbles, you
can start by not letting them form, such as in allowing banks to
conceal the losses of assets on their books - in essence inflating
those asset values.

SEC Clears U.S. Banks to Postpone Writedowns on Value of
Some Securities-

And so it begins, the obfuscation of
true market values of assets held on bank's books. They can't fool me though.
Now, preferred stock is to be called debt. When is debt to be called preferred stock.
When are we going to be notified if or when the assets a bank is holding and
paid for with leverage have dropped in value by 70%. Doesn't that make the bank
worth less. Maybe not, after all stock is really debt, right?

S&P May Downgrade $280.1 Billion of Alt-A Mortgage Debt
Amid Delinquencies -
But it doesn't really matter because
if you read the article above, banks don't have to write it down now. You know,
if I run into the middle of the highway, as long as I close my eyes so I can't
see the cars I'll be just fine.

Bush Says U.S. Taxpayers Will Get Back `Most' of Money Under
Bank Rescue-
course they will. Bush and his cronies have ever been the bastion of
credibility (Reggie Middleton says, "Don't believe Paulson": S&L 2.0 - bank failure redux, Is Paulson to be trusted, or is this Bush Administration Shock and Awe, 2.0? and Reggie Middleton asks, "Do you guys know who you're messin' with?"). Just look at bullet point one above: all of those levered equity
securities bought at the top of the stock bull run from 2003 to 2007 will
generate tons of return for tax payer as they overpay to buy them up.

What does all this have to do with my buying of the European banks bear positions? Well, most are still much, much too optimistic about the financial sectors prospects here. The Monday rally was an opportunity to go shopping, and shopping I did, for price and value diverged even farther. While I won't divulge what I bought, I will share a little anecdotal research (more empirical research on this may be available to professional level subscribers next week). Before we go on, if you haven't read Interesting Lehman email, it is must reading to fully grasp the weight of the rest of this article.

Published in BoomBustBlog
Thursday, 16 October 2008 02:00

I can tell you who's holding the bag

As a continuation of the
recent posts on credit default swap risks, I am releasing my
proprietary study of Lehman's counterparties. Please read
"Interesting Lehman email" and "Do you who's going to screw who next week?" to get a clear background on the chain of posts (and the ample comments beneath the posts) that generated this one.
It would appear that I am on the right track, with extreme resources
being dedicated by already bankrupt companies to unwind trades that
were supposedly "netted out" already (Lehman Plans to Hire 200, Unwind Derivatives Trades: WSJ Link
), monolines seeking government bailouts (Ambac, Bond Insurers Will Present Plan to Tap Treasury Funds, Callen Says), and hedge funds raising substantial amounts of cash in a hostile market:

was very, very specific in my assertions that the hedge fund bubble has
burst, and I was even at risk of sticking my toe in the bubble since I
had my own vehicle primed and ready to go. The fund formation process
combined with my proprietary trading clued me in on the maelstrom well
before the media started running the stories. I urge all who have done
so, to please read "
In the Great Global Macro Experiment, the next bubble to burst is...". It is quite tell tale and also reveals a lot about your author. Now, back to the topic at hand.

CDS exposure report was a quick and dirty overnight project and thus
not perfect, for I didn't want to distract my teams from their other
projects. I will offer most of it here for free, but the actionable
items are for paying subscribers (all levels) only. I stripped out the
companies that I felt were actionable in the near term to present it to
the general blog. This the process that was used to develop a
list of companies with exposure towards Lehman's debt and equity.

We extracted data for individual companies (approx 100). Some of the
companies (in addition to the stated exposure herein) have also
disclosed expected losses or write-down on the corresponding Lehman
exposure. In cases where this information was not available we have
computed expected loss based on the recovery rate of 15 cents (US) on a

We then used the following process to come up with a shortlist of 9 companies which may find it difficult to sustain the pressure from expected losses as a result of Lehman's failure and inability to repay.

Stage 1:

After computing expected loss on Lehman exposure we have computed
expected loss-to-shareholders' equity to determine the relative
magnitude of loss each company could undertake..

Stage 2:

In addition to expected loss-to-shareholders' equity we have also
looked into factors like absolute share price, relative decline in
share price over various periods and price-to-book value to indentify
potential companies that are prone to trouble.

· Based on the factors above we have indentified a list of 9 companies (for subscribers) which meet each of the following criteria

1. Expected loss-to-share holder's equity =>1.0%

2. Absolute share price >$15

3. Share price decline is less than 30% in last 3 months and less than 60% decline in the last 12 months

4. Price to book value more than 1.0x

Subscribers may download the actual spreadsheet here: icon Lehman Brothers CDS exposure_impact (153.5 kB 2008-10-16 19:12:02), all others can see the sanitized list below in HTML. (Update 1 -
There is a typo in this dowload. We inadvertently included price for
AMG instead of AGM. Federal Agricultural Mortgage (AGM) should go off
the list since its share price is less than $15, a criteria we used to
shortlist the companies. However, the data on exposure to Lehman ($60
bn) is correct. This makes their exposure as % of shareholders equity
to 25% (on a base of $230 bn of equity), which is significant.

It is obvious that there are still too many media types who don't read Reggie Middleton. From teh UK Telegrah: Fears of Lehman's CDS derivatives haunt markets:
It is a full week after bankers gathered in New York to start sorting
out the derivatives mess left by the bankruptcy of Lehman Brothers. We
still do not know who is on the hook for some $360bn of default
insurance, or how much they will have to pay.

Published in BoomBustBlog
Monday, 13 October 2008 02:00

Interesting Lehman email

Here is a short email exchange on the recent Lehman auction and announced CDS settlement. It is timely considering my admonitions in the Asset Securitization Crisis series and the Great Global Macro Experiment (must read). The explanation was broken down with numbers for those who use the left side of their brains:

By the way, what is your thought on the Lehman CDS settlement situation? I smell something funny there.

The financial media has crowed in adulation that "only $6B was paid out on ~$400B of nominal derivatives". But wait a minute. Didn't the auction yield a $.91 to face value settlement? Doesn't that mean there will be, in aggregate, about $36B of write-downs? Yes, $6B may have changed hands, but that is on a reduced nominal value, which HAS to cost someone.

If so, where will those losses land, and when?

I don't know enough about this process to answer those questions. But it certainly has occurred to me that all the orderly derivatives settlement process gains is that massive losses will be bled out over a long period of time, rather than all derivatives imploding at once. So we get banks and other financials under-performing for more years, instead of all going to zero right now.

The reply:

The investors footed the bill for much of the reduced nominal value, and the creditors and clients of the bank. Some prime broker clients will get pennies back on the dollar for thier accounts and have been forced to side pocket those assets, thus freeze their own clients money (much of which will not be returned at all).

As for the CDS payout, they were referring to a netting process, where bank A sold protection for Lehman to bank C, but bought similar 80% protection from bank B. Netted out, only 20% of net exposure had to be paid, THEORETICALLY.

Here's the real world:
The problem with the netting argument is that everyone is assuming bank B has the 80% to cough up, which they don't because they bought 80% protection from insolvent monoline MBIA to hedge them against bank A, but insolvent mononline MBIA reinsured with insolvent monoline Ambac, who sold protection to banks A, B, C, and D at 120x leverage and can't pay all of them at once.

Hence, bank C is f1cked, because bank A is f2cked by bank B, who got f3cked by MBIA who is currently getting f4cked by Ambac who can't pay everybody (or maybe even anybody, now), hence can generally be considered to be f5cking everybody involved.

Even common sense tends to evade these smart people. This is what happens when you are allowed to write OTC insurance without reserves, an exchange and regulations!

I expect this whole house of cards to collapse any time now. The problem is the revolution will not be televised.

You see, I don't use swaps, the primary reason being that when my gains are the juiciest, the likelihood of getting paid are the slimmest. Banks are rallying hard, again. I am slowly deploying my ample store of dry powder... Again, price and value have diverged significantly. Before we go on, make sure you have read:

Now, keeping the email exchance above in mind, notice what this astute gentlemen had to say (I have not verified the dates, but they seem right):






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Distracted by worldwide stock market
crashes, attention shifted away from Lehman’s derivatives’ payouts
scheduled for October 21. Recovery value has been set at 8.625 cents
per $1.00, which means that sellers of credit protection must pay
91.375 cents to the buyers (according to Creditex, the company that holds auctions).

More than 350 banks and investors signed up to settle credit-default
swaps tied to Lehman. The list of participants in the auction includes
Newport Beach, California-based Pacific Investment Management Co.
PIMCO, manager of the world’s largest bond fund, Chicago-based hedge
fund manager Citadel Investment Group
LLC and AIG, the New York-based insurer taken over by the government,
according to the International Swaps and Derivatives Association in New

According to JPMorgan, the largest foreign bank holders of Lehman’s
derivatives are Deutsche Bank, Barclays, Societe Generale, UBS, Credit
Suisse and Credit Agricole. Overall, as of June 30, 2008, the top ten
US banks in terms of derivatives exposure were: JPMorgan Chase, Bank of America,
Citibank, Wachovia, HSBC USA, Wells Fargo, Bank of New York, State
Street Bank, SunTrust Bank, and PNC Bank, according to the Comptroller
of the Currency Administrator of National Banks’ Quarterly Report on Bank Trading and Derivatives Activities for the second quarter of 2008....

... Washington Mutual could be another story. It’s Credit Event Auction
will settle, meaning prices will be determined, on October 23. Just
last week there were credit events at the largest three Iceland banks,
all of which have large quantities of derivatives outstanding. These
are all financial institutions; industrials haven’t started yet.

Published in BoomBustBlog