I have fixed the archived links, so all links to all articles are
now working properly. This is the Asset Securitization Crisis roadmap
to date. Feel free to spread it around.

The Asset Securitization Crisis Analysis road-map to date:

  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. Pt one of three of my opinion of HSBC and the macro factors affecting it
Published in BoomBustBlog

I warned of this as early as September of last year, and in May I issued two verbose reports detailing this distinct possibility and what I believe to be it's likely consequences. Be aware, Lousiana and California are far from the only states in this situation. The recent bull run has set up some of the most vulnerable companies for a devastating cash. I am sitting on almost 66% cash, being forced to take or hedge profits due to the intensity of the bear rally which shocked even me. There is an immense amount of money to be made through this wholesale destruction of faux wealth that has been accumulated over the last decade, (hence transfer of real wealth to those who are properly prepared), unfortunately the occassion is somber and depressing. It is most unfortunate that the actual problems are not being addessed, causing the symptons to gain free reign over our way of life. Read on...

From the San Francisca Examiner:

Gov. Arnold Schwarzenegger
plans next week to slash the pay of more than 200,000 state workers to
the federal minimum of $6.55 per hour to help ease the state's budget
crisis, according to a draft executive order obtained by The Chronicle
on Wednesday.

The governor also will order an end to overtime pay for all but
critical services, a freeze on state hiring and the immediate layoff of
nearly 22,000 temporary, seasonal and student workers.

More from the Wall Street Journal
States Slammed by Tax Shortfalls[Go to article]
States are being forced to slash spending and cut
jobs in order to close a projected $40 billion shortfall in the current
fiscal year. That gap, more than triple the size of the previous
year's, is the result of broad economic weakness at the state and local
levels that could cause pain throughout this year and into 2010, a
report found. (Report)

"As a result of the late state budget, there is a real and
substantial risk that the state will have insufficient cash to pay for
state expenditures," the executive order states.

Schwarzenegger's staff would neither confirm nor deny that the
governor plans to issue the executive order, but sources said he could
take action as early as Monday. The state, facing a projected $17.2
billion budget deficit for the fiscal year that began July 1, has not
approved a budget...

But administration officials,
who asked to remain anonymous, said that about 200,000 of the state's
245,000 workers, both hourly and salaried, will see their pay trimmed
back to the federal minimum wage of $6.55 an hour, saving the state up
to $1.2 billion a month. Dropping the temporary and short-time workers
will save an additional $28.5 million each month.

While the layoffs could be made immediately, the pay cuts might not be completed until mid- or late August.

The proposed pay cut for hourly employees would take their wages
well below the state minimum wage of $8 an hour. But a 2003 California
Supreme Court decision allows the state to chop workers' pay to the
federal minimum when a state budget has not been enacted.

"While we've had late budgets in the past, the critical difference
this year is cash," an administration official said. "We have not had a
situation in recent years that's the same as the cash-starved situation
that we may face in September if we don't have a budget in place."...

While California needs to
have about $2.5 billion in cash on hand at any given moment to cover
the state's ongoing expenses, the Golden State is projected to have
just $1.8 billion at the end of September, the official said.

But the governor's plan could face an immediate challenge from
Democratic state Controller John Chiang, who will continue to pay state
workers their full salaries, even in the face of Schwarzenegger's
executive order, said Hallye Jordan, a spokeswoman for the controller.
The governor will have to take Chiang to court if he wants to stop him,
she said.

"The controller hasn't seen any executive order, but he would urge
the governor to rethink his proposal," she said. "This hasn't been
addressed by the courts and if it's ruled illegal, it could cost the
state a tremendous amount in damages.

Now, read in full how I feel this will affect the muni bond system, the insurers, and the banks. See Reggie Middleton on Municipal Bond Market and the Asset Securitization Crisis part 1 (primer) and part 2 (my more intricate thoughts).

Published in BoomBustBlog

This is another one of those analyses that you won't be able to get
from your local brokerage house, along the same vein as my last GGP
post (GGP and the type of investigative analysis you will not get from your brokerage house
). It is the stuff only available from the blogoshpere minority, or
high end buy side groups (who really tend not to share much).

I'm a private investor and I pride myself on an analytical approach
to investing. I try very hard to look at things from a scientific
perspective of risk vs. reward. It is an indomitable tenet, one that I
attempt to instill within my three children, and one which has (at
least for the last 8 years or so) has provided me with an investment
return that is multiples of the broad market. Unfortunately (or maybe
fortunately, in regards to my investment record), it is one which is
not shared by most of the analyst community and those that follow them.

This brings me to the issue of Goldman Sachs. I have been bearish
on commercial, mortgage and investment banks for over a year now, and
have made a penny or two from this outlook. In doing this, I noticed
the illogical reverance that Goldman Sachs has recieved, both from the
analytical community and the media (bolstered by the name brand talking
heads). I never did buy into it. Goldman is a fine, well run, well
respected brokerage/banks, but it is still just that. They hire the
same people, who went to the same schools to get the same education, to
use the same strategies to trade/advise on the same products in the
same markets as all of the other banks. To assert that thier shit
doesn't stink breaks from my scientific method of analysis. So, let's
take a more analytical look at the media's Golden Boys...

Published in BoomBustBlog
Thursday, 03 July 2008 01:00

CDS stands for Credit Default Suckers...

I've been preaching about the risks the CDS market poses to the
financial system for some time now. Since the monolines faux business
model has been laid bare, we will start seeing some real action in this
arena. For those who don't want to take my anecdotal quips as gospel, I
actual go in depth through Reggie Middleton on the Asset Securitization
Crisis Series - The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath!. A worth read for those not familiar with the Credit Default Sucker's market.

Now, to the point of the post. UBS is in a lot of hot water these
days. Despite being eyeballs deep in rapidly disintegrating, highly
leveraged trash assets they are also often in hot water. Reference the
financial times:

In depth: UBS - Apr-01

UBS faces civil charges over securities sales - Jun-26

Published in BoomBustBlog
Friday, 20 June 2008 01:00

Now, they're all holding the bag!

From CNBC: Moody's Cuts MBIA, Ambac Top Insurance Ratings

stripped the insurance arms of Ambac Financial Group and MBIA of their
AAA ratings, citing their impaired ability to raise capital and write
new business... Demand for their insurance wraps has also
effectively dried up on concerns over losses the companies will take
from insuring risky residential mortgage-backed debt.

Standard & Poor's stripped both insurance arms of their top ratings on June 5.

cut Ambac Assurance three notches to "Aa3," the fourth highest
investment grade, and downgraded Ambac Financial three notches to "A3,"
the seventh highest investment grade, from "Aa3."

Insurance was cut five notches to "A2," the sixth highest investment
grade, and MBIA Inc was cut five notches to "Baa1," three steps above
junk, from "Aa2."...

MBIA said Moody's action will give some holders of guaranteed
investment contracts the right to terminate the contracts or to require
that additional collateral be posted. The company said it has "more
than sufficient" liquid assets to meet those requirements. Yeah, okay. Everything that has come out of Management's mount in the last year has been false - practically every defensive public statement. They can't even spell credibility at this point.

This is a Turning Point Ladies and Gentlemen!

IMO, MBIA's management is the lack of wisdom in action. I know it is easy to kick someone whent they are down, and that is something that I definitely do not aim to do. Yet, I have questioned management's competency for some time, way before it was popular to do so.

This is the dilemma. Everybody and their grandaunt's cousin knew the monoline wraps weren''t worth the toilet tissue their were contracted on, but they all played along with the triple ratings agency game. Realistically, in terms of perception of risk, we are in the same place we were in two months ago.

And to think, there is no clearing house, no guarantee of settlement, no standardized credit or counterparty rating. Who knows who the hell will pay up and who will not! I have already bet my money that the monolines wouldn't be able to pay up, and I made a penny or two on that wager. The game is now afoot.

The growth in CDS market in the last few years has
outstripped that of the US
equity and bond markets

The credit
derivatives market has grown at a remarkable pace as reflected from the
tremendous increase in total notional amount outstanding over the last few
years. The total notional amount of credit derivatives as of June 2007 increased
to US$42.6 trillion, an increase of 109% over the US$20.4 trillion reported in
June 2006. This has been driven by both the rise in single name CDS and the multi
name CDS instruments. The significant rise in the multi name CDS (traded
indices) has notably surpassed the growth in single name CDS. Single name CDS’ total notional amount
outstanding has increased from US$7.31 trillion in June 2005 to US$24.2
trillion in June 2007 while the multi name CDS has grown from US$2.9 trillion
in June 2005 to US$18.3 trillion in June 2007.


Source: Thomson Research

From an accounting perspective, we should see big things happening though. Now, some real transparency should be coming to light. Banks and other entities will have to start marking things down significantly, contracts that will get called will bankrupt the monolines, who will either refuse or be unable to pay. Level 3 asset concentrations and counterparty risk will be the poisons du jour. Who is the most toxitic? The CDS market will show the cracks that I have been predicting for some time as the dominoes go horizontal at a hastened pace. Even the speculators, re: Ackman, et. al. may have problems. Not everyone is going to get paid on their CDS exposure, because many guys on the other side (this is read as the counterparty risk that I have been crowing about for one year) just won't have the money to pay up. Trust me. If you haven't unwound already, God Bless the side pocket clause!

... for my next prediction, a lot of people may benefit from revisiting my "I know who's holding the bag" and "The Next Shoe to Drop: The CDS market, beware what lies beneath " articles... We will be testing the Fed's ability to rescue these banks, for although they have bandaged the liquidity wound, what's killing the banks is the insolvency disease - something the Fed is powerless to mitigate. This is why Paulson was on TV yesterday pushing to hasten the Fed's regulatory power increase.

We very well soon see where I got the moniker, "The Riskiest Bank on the Street" from. See icon Morgan Stanley_final_040408 (1.38 MB). I received some notoriety after successfuly calling the Bear Stearns collapse (Is this the Breaking of the Bear?). Many who don't follow me closely may not realize how similar I consider Bear Stearns and Morgan Stanley. Morgan Stanley's net credit, counterparty, and level 3 exposure was the reason why I did the deep dive on it instead of Lehman, despite the fact that Lehman had more CRE exposure in proportion to its equity. Methinks the street may be looking at the wrong bank to fail. I may be wrong, we shall see. I made a decent profit off of Lehman anyway since those who follow the blog realized that we discovered Lehman's foibles way before most took notice. I wrote the following in April, right after the Bear debacle:

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan
Stanley’s level 3 asset exposure, which stood at 261% of its equity as
of February 29, 2008, is likely to cause a significant drag on its
valuation in the near future. These assets, for which the bank uses
proprietary models to gauge their value, will witness the largest
write-downs of all asset categories amid the current credit market
turmoil. When compared with other leading investment banks, Morgan
Stanley clearly stands out to be the most vulnerable to falling values
in these hard-to-value assets. It is worthwhile to mention that Bear
Stearns, which last month witnessed significant erosion in its market
capitalization, had level 3 assets equal to 239% of its equity, next
only to Morgan Stanley. Although the Fed has mitigated liquidity
concerns of investment banks in significant part, the balance sheet
solvency is a far more difficult problem to address – and one in which
Morgan Stanley leads the pack.

Just so no one thinks I am following the crowd, I wrote this the 2nd week of February:

Failure of bond insurers increases counterparty credit risk

Bond insurers have guaranteed a monstrous $2.4 trillion of outstanding
debt besides providing insurance coverage to troubled structured
finance products such as CDOs. Banks active in the ABS RMBS and CMBS
real estate markets have more than one reason to worry having bought
protection through credit-default swaps (CDS) from bond insurance
companies. Since the CDS market is not regulated, it is difficult to
assess the amount of exposure banks have to bond insurer counterparty
risk. ACA Capital Holdings is facing difficulties in paying claims due
to its exposure in the CDO sector and subprime market. This prompted
Merrill Lynch to write down its exposure to ACA by $1.9 billion. Sell
side analysts such as Meredith Whitney of Oppenheimer, estimate that
banks may have to write off securities (worth $10.1 billion) insured
with ACA. Morgan Stanley’s exposure to net counterparty credit
aggregates $51 billion. Nearly 27% of this was rated BBB and lower as
of 30 November 2007. This reflects the $10 billion increase since
August 31, 2007.

Morgan Stanley Issued Securities with Exposure to Ambac and MBIA

Morgan Stanley has exposure to bond insurers through bonds insured by
them and their status as counterparties to derivative contracts. The
inability of bond insurers to pay claims has become a serious concern
for parties exposed to such firms.

The significant concentration in subprime home equity lines, who are subject to playing 2nd
fiddle to the primary lender in first position in terms of claim on the
what is increasingly highly encumbered property, leaves MS open to
unprecedented losses - losses that can extend significantly past the next two quarters.

Deal Type

Min Rating

Sum of Par Amount

Sum of Potential Losses














CDO Total






















CMBS Total



Home Equity



















Home Equity Total



















RMBS Total










(Other) Total



Grand Total



Counterparty credit exposure (in $ million)


Source: Company data

So, where is all of this exposure and risk hidden?

Unconsolidated VIEs could aggravate woes

VIEs have tormented most Wall Street financial majors—several of them
have had to consolidate their VIEs to increase liquidity and limit
losses. These innovative, structured entities were introduced to boost
earnings without transferring actual risk into the balance sheets of

Morgan Stanley has significant exposure to VIEs, with the maximum loss
ratio averaging roughly 50% in recent years. The large exposure ($37.7
billion in 4Q 07), high loss ratio and adverse market conditions could
force the company out of business if its maximum loss assumptions
become reality. Morgan Stanley’s unconsolidated VIEs comprise the most
troublesome asset categories – MBS & ABS portfolios (worth $6.3
billion), credit & real estate portfolios ($26.6 billion) and some
structured finance products ($8.6 billion). Loss exposure in the credit
& real estate portfolio is not expected to be lower than 70%
considering the slump in housing demand, falling home prices and rising
foreclosures. The growing housing inventory across the U.S. has also
raised concerns about the disposal of these assets. Home prices across
the U.S. declined 7% (on average), while foreclosures increased 20%
during the past year alone. This scenario reflects the bleak prospects
of the housing industry and the securities linked to it.

Unconsolidated VIEs, Exposure to loss (in $ mn) and loss ratio (in %)


Source: Company data

Unconsolidated VIE's

FY 2007

$ mn

Unconsolidated VIE assets

Maximum exposure to loss

Loss ratio %





Credit & real estate




Structured transactions








To forecast these loss ratios, we
have used the maximum exposure to loss as the worst case scenario. For
the base case, we expect the loss ratio to be lower than the maximum
exposure to loss.

Base Case

Optimistic Case

Worst Case

Mortgage and asset-backed securitizations




Credit and real estate




Structured transactions




Base Case

Optimistic Case

Worst Case

Mortgage and asset-backed securitizations




Credit and real estate




Structured transactions




Total Losses in $ million




This is the "Riskiest Bank on the Street", as updated in April right after I liquidated the largest position in my proprietary portfolio, Bear Stearns puts from the year before:

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan
Stanley’s level 3 asset exposure, which stood at 261% of its equity as
of February 29, 2008, is likely to cause a significant drag on its
valuation in the near future. These assets, for which the bank uses
proprietary models to gauge their value, will witness the largest
write-downs of all asset categories amid the current credit market
turmoil. When compared with other leading investment banks, Morgan
Stanley clearly stands out to be the most vulnerable to falling values
in these hard-to-value assets. It is worthwhile to mention that Bear
Stearns, which last month witnessed significant erosion in its market
capitalization, had level 3 assets equal to 239% of its equity, next
only to Morgan Stanley. Although the Fed has mitigated liquidity
concerns of investment banks in significant part, the balance sheet
solvency is a far more difficult problem to address – and one in which
Morgan Stanley leads the pack.

Bank Level 1 Assets Level 2 Assets Level 3 Assets Shareholder Equity Total Assets Level 1 Assets-to-Total Assets Level 2 Assets-to-Equity Level 3 Assets-to-Equity Leverage (X)
Citigroup $223 $934 $133 $114 $2,183 10.2% 822% 117% 19.21
Merrill Lynch $122 $768 $41 $32 $1,020 12.0% 2405% 130% 31.94
Lehman Brothers $73 $177 $39 $26 $786 9.2% 687% 152% 30.59
Goldman Sachs $122 $277 $72 $47 $1,120 10.9% 586% 153% 23.71
Morgan Stanley $115 $226 $74 $31 $1,045 11.0% 723% 236% 33.43
Bear Stearns $29 227 $28 $12 $96 30.7% 1926% 239% 8.15
Based on latest quarterly filings and transcripts
the growing proportion of level 3 assets in Morgan Stanley’s total
asset exposure is raising investors’ concerns over expected write downs
in the coming quarters. The bank’s level 3 assets have increased partly
due to re-classification of assets from level 2 to level 3 on account
of unobservable inputs for the fair value measurement. During 4Q2007,
Morgan Stanley re-classified $7.0 bn of funded assets and $279 mn of
net derivative contracts from level 2 to level 3. Morgan Stanley’s
level 2 assets-to-total assets ratio declined to 5.2% in 4Q2007 from
8.9% in 1Q2007 while its level 3 assets-to-total assets increased to
7.0% in 4Q2007 from 4.3% in 1Q2007 indicating growing uncertainty
associated with valuation of assets not readily marketable. The trend
can be expected to continue in the coming quarters as uncertainty
associated with realizing values from illiquid assets continues to grow.
High leveraging could hinder capital raising abilities: While
expected asset write-downs could continue eroding Morgan Stanley’s
equity at least for the next few quarters, the company’s
higher-than-peers leverage levels could prove to be an impediment in
raising additional capital to maintain its statutory capital levels.
Morgan Stanley’s leverage (computed as total tangible assets over
tangible shareholders’ equity) stood at 37.3X as of February 29, 2008,
while the bank’s balance sheet size had been reduced to $1,091 bn as of
that date from $1,182 bn on November 30, 2007. The bank’s leverage is
the highest among its peers which could be a cause of concern amid
falling income levels and tight liquidity conditions in the financial
* Adjusted assets / adjusted shareholder's equity
Morgan Stanley taking initiatives to “de-risk” its balance sheet: In
the wake of issues underpinning the current crisis in the markets,
Morgan Stanley is making continued efforts to “de-risk” its balance
sheet by reducing its exposure to risky credit positions. Morgan
Stanley’s total non-investment grade loans decreased to $26 bn in
1Q2008 from $30.9 bn in 4Q2007. In addition Morgan Stanley reduced its
gross exposure towards CMBS and RMBS securities to $23.5 bn and $14.5
bn, respectively, in 1Q2008 from $31.5 bn and $16.5 bn, respectively,
in 4Q2007.


Significant counter-party risks from monoline downgrades to result in further write-downs

hedging does function as an effective tool in minimizing loses from
write-downs of dubious assets, hedging in the form of protection from
monolines/bond insurers carries associated counterparty credit risks
which cannot be ignored in the current environment of continued
weakening of monolines. An increasing probability of counterparty risks
materializing for investment banks from the deteriorating financial
position of the monolines could contribute to further asset write-downs
by the banks. It is estimated that the top five US investment-banks
have a combined $23 bn in uncollateralized exposures to triple-A rated
counterparties part of which is with the monocline bond insurers
including AMBAC, MBIA (may face downgrade from Fitch, same with Ambac),
and FGIC (is now rated as junk), which have been a subject of
downgrades in the last few months. Merrill Lynch’s total
uncollateralized exposure to triple-A counterparties stood at $7.1 bn
as of August 31, 2007, while that of Morgan Stanley was $7 bn as of
that date. The corresponding figures for GS, Lehman and Bear Sterns
were $4.7 bn, $4 bn and $330 mn, respectively. Merrill Lynch has
reported that around 50% of its total hedging is in the form of
monoline insurance, giving a fair indication of the possible
write-downs resulting from downgrades of monolines. Merrill Lynch also
reported a $3.1 bn asset write-down in 4QFY07 in response to a
downgrade of ACA Capital (to which it had an exposure) to junk status.
of February 29, 2008, Morgan Stanley had $4.7 bn aggregate exposure
towards monolines with a $1.3 bn exposure in ABS bonds, $2.6 bn in
municipal bond securities and $0.8 bn in net counter party exposure.
The deterioration of credit market coupled with significant losses
suffered by monolines had caused downgrades of monolines. Any further
downgrades of monolines could result in additional write-downs by
financial institutions and adversely affect the financial markets.
Morgan Stanley recorded approximately $600 mn write-down in 1Q2008 on
account of its exposure from monolines.
estimates that the total hedges to CDO exposures by bond insurers are
currently around $125 bn, though the location of these hedges is not
entirely known. A separate report by Oppenheimer & Co estimates
that the total write-down by the financial institutions resulting from
potential rating downgrades of monolines could range between $40 bn to
as high as $70 bn, with Citigroup, ML, and UBS being the most
vulnerable as they together hold a large chunk of the credit market
risk associated with bond insurers. The coming quarters could thus
witness more significant assets write-downs if monolines are
possible relief comes from the recent developments whereby monolines
have been successful in raising capital to maintain their AAA ratings. Earlier,
in March 2008, both S&P and Moody’s affirmed AAA and Aaa ratings,
respectively, to AMBAC after it raised $1.5 bn through sale of common
stock and convertible units.
factor which may reinforce the banks’ counter party risks on monocline
exposure are the recent developments which indicate that the monolines
may be looking for means to terminate their guarantee contracts with
the banks to evade their liabilities. A case in point is the legal
battle initiated between Merrill Lynch and Security Capital Assurance
(SCA) wherein Merrill Lynch sued SCA’s XL Capital Assurance unit on the
ground that the latter refused to honor the commitments arising on the
bank’s CDS worth $3.1 bn. SCA has in turn alleged that Merrill Lynch
had not honored the contractual terms by transferring the control
rights on the CDOs to a third party. More such legal battles could
follow creating increased uncertainty on the true extent of hedging
exercisable on monocline exposure.


Hidden losses from unconsolidated VIE’s a cause of concern for Morgan Stanley

Stanley has a significant exposure to MBS, ABS, credit and real estate
assets and other structured transactions through VIEs. As at November
30, 2007 Morgan Stanley consolidated $22.4 bn of assets from VIEs, with
a maximum loss exposure of $17.6 bn. In addition, the bank also has
$37.7 bn in exposure through unconsolidated VIEs with a maximum loss
exposure of $15.9 bn, yielding a maximum loss-to-total exposure at
42.4%. Morgan Stanley’s total exposure towards unconsolidated VIEs is
in some of the riskiest asset class categories, including a $7.2 bn
exposure towards MBS and ABS securities (maximum loss-to-exposure of
3.9%), $20.3 bn towards credit and real estate (maximum
loss-to-exposure of 65.4%) and $10.2 bn towards structured transactions
(maximum loss-to-exposure of 23.9%).
Consolidated VIE's ($ mn) 30-Nov-07
US$ mn VIE
assets consolidated
Maximum exposure to loss
Mortgage and asset-backed securitizations 5,916 1,750
Municipal bond trusts 828 828
Credit and real estate 5,130 5,835
Commodities financing 1,170 328
Structured transactions 9,403 8,877
Total 22,447 17,618
Unconsolidated VIE's ($ mn) 30-Nov-07
US$ mn VIE
assets not consolidated
Maximum exposure to loss
Mortgage and asset-backed securitizations 7,234 280
Credit and real estate 20,265 13,255
Structured transactions 10,218 2,441
Total 37,717 15,976
Net losses Optimistic Case Base Case Worst Case
Mortgage and asset-backed securitizations 28 42 84
Credit and real estate 2,187 3,314 6,628
Structured transactions 564 854 1,709
in US$mn
2,779 4,210 8,420

can be ascertained from its high maximum loss-to-exposure ratio of
65.4%, the credit and real estate product is the most vulnerable of all
the products in respect of a probability of defaults considering that
most of the US housing problem is linked to loans originated with poor
underwriting standards to marginal buyers at the peak of the housing
bubble. Falling housing prices coupled with stringent lending standards
are making it increasingly difficult for borrowers to refinance
existing loans resulting in higher delinquency and foreclosures for
these loans. Under our base case scenario we have estimated total
losses of $4.2 bn from unconsolidated VIEs primarily off losses from
the credit and real estate sectors.
it is worth mentioning that some investment baking firms (prominently
UBS and Lehman) are spinning off or considering a spinoff of their
riskier assets into separate subsidiaries, CLOs and SIVs as an
off-balance sheet exposure in an attempt to shrink their balance sheet
through accounting shenanigans designed to deceive investors by
presenting a rosy picture of their financial affairs.

Worsening credit market to impact Morgan Stanley’s financial position

current gridlock in the credit market has drastically pulled down the
mark-to-market valuation of mortgage-backed structured finance
products, resulting in significant asset write-downs of banks and
financial institutions. It is estimated that further write-downs by
investment banks could touch $75 bn in 2008 after an estimated $230 bn
already written off since the start of 2007. With the situation not
expected to improve in the near-to-medium term, investment banks are
likely to face a sizeable erosion of their equity from large
write-downs in the coming periods. Though the recent mark-down
revelations by UBS and Deutsche Bank have injected some positive
sentiment in the global capital markets with the hope that the credit
crisis has reached an inflection point, it is overly optimistic to
believe that the beginning of the end of the current turmoil is at hand
before the causes of the turmoil, tumbling real asset prices and
spiking credit defaults, cease to act as catalysts.
* expected
Stanley wrote off a significant $9.4 bn of its assets in 4Q2007.
However, the write down in 1Q2008 was much lower with $1.2 bn mortgage
related write-down and $1.1 bn leveraged loan write-down, partly offset
by $0.80 bn gains from credit widening under FAS159 adjustments. One of
the factors which the bank considers while estimating asset write-downs
is the movement in the ABX index which tracks different tranches of CDS
based on subprime backed securities. Nearly all tranches of ABX index
have witnessed a significant decline over the last six months. While
Morgan Stanley’s 4Q2007 write-down of $9.4 bn appeared in line with a
considerable fall in the ABX index during the quarter, a similar nexus
is not evident for 1Q2008. Morgan Stanley recorded a gross write-down
of $2.3 bn in 1Q2008 though the decline in ABX indices seemed
relatively severe (however not as steep as in the preceding quarter).
The disparity raises a concern that Morgan Stanley might report more
losses in the coming periods.
ABX BBB indices (September 26, 2007, to April 2, 2008) Source: Marki.comt Although
the ABX indices showed a slight recovery in March 2008, this is
expected to be a temporary turnaround before the indices resume their
downward movement owing to expected continuing deterioration in the US
housing sector and mortgage markets. The following is a detailed, yet
not exhaustive, example of Morgan Stanley's "hedged" ABS portfolio -
icon Morgan Stanley ABS Inventory (1.65 MB)6.
is a parenthetical because we believe that large scale investment bank
hedges are far from perfect. We discuss this later on in the report.
US housing markets are yet to stabilize and housing prices are still
above their long-term historical median levels, leaving scope for a
further downside in prices. Between October 2007 and January 2008, the
S&P Case Shiller index declined nearly 6.5% (with 2.3% decline in
January 2008 alone). We would like to make it clear that although the
CS index is an econometric marvel, it does not remotely capture the
entire universe of depreciating housing assets. It purposely excludes
those sectors of the housing market that are hardest hit by declines,
namely: new construction (ex. home builder finished inventory), condos
and co-ops, investor properties and “flips”, multi-family properties,
and portable homes (ex. trailers). Investor properties and condos lead
the way in defaults due to excess speculation while new construction
faces the largest discounts, second only to possibly repossessed homes
such as REOs. A decline in this expanded definition of housing stock’s
pricing could result in increased defaults and delinquencies,
significantly beyond that which is represented by the Case Shiller
index, which itself portends dire consequences.
credit spreads continue to widen over the next few quarters, the assets
would need to be devalued in line with risk re-pricing. Morgan Stanley
and the financial sector in general, are expected to continue with
their balance sheet cleansing exercise, recording further asset
write-downs till stability is restored in the financial markets.
it is believe the expected continuing fall in the security market
values would indicate more write-downs in the coming quarters, a part
of this could be set-off under FAS159 by implied gains from write-down
of financial liabilities off an expected widening of credit spreads.
Morgan Stanley is expected to record assets write-down losses of $16.5
bn and $7.6 bn in 2008 and 2009, respectively, considering the bank’s
increasing proportion of level 3 assets amid falling security values.
This would be partially off-set by FAS159 gains of $930.8 mn and$116.1
mn in the two years off revaluation of its financial liabilities. It is
important to note the fact that FAS 159 gains are primarily accounting
gains, and not economic gains and they do not truly reflect the
economic condition of Morgan Stanley. Of the $18.3 bn of total
liabilities for which the bank makes adjustments relating to FAS159,
$14.2 bn and $3.1 bn of liabilities relate to long-term borrowings and
most of these securities are traded in the secondary market, it would
be difficult for Morgan Stanley to translate these accounting gains
into economic gains by purchasing them at a discount to par during a
widening credit spreads scenario.
in simpler terms, marketable securities can be purchased at a
discount to par if credit spreads increase as MS debt is devalued.
Thus, theoretically, MS can retire this debt for less than par by
purchasing this debt outright in the market, and FAS 159 allows MS to
take this spread between market values and par as an accounting profit,
presumably to match and offset the logic in forcing companies to market
assets to market via FAS 157. In reality, only marketable securities
can yield such results in an economic fashion, though companies that
would be stressed enough to experience such spreads probably would not
be in the condition to retire debt. In Morgan Stanley’s case, these
spreads represent non-marketable debt such as bank loans, negotiated
borrowings and deposits. These cannot be purchased at less than par by
the borrower, thus any accounting gain had through FAS 159 will lead to
phantom economic gains that don’t exist in reality. For instance, a $1
billion bank loan will always be a loan for the same principle amount,
regardless of MS’s credit spreads, unless the bank itself decides to
forgive principal, which is highly unlikely. It should be noted that
Lehman Brothers actually experienced an economic loss for the latest
quarter of about $100 million, but benefitted by the accounting gain
stemming from FAS 159, that led to an accounting profit of
approximately $500 million. This profit, which sparked a broker rally,
was purely accounting fiction. Similarly, Morgan Stanley (in economic
profit, ex. “real” terms) overstated its Q1 ’08 profit by approximately
50%. This overstatement apparently induced a similarly rally for the
brokers. Quite frankly, we feel the industry as a whole is in a
precarious predicament due to dwindling value drivers, a cyclical
industry downturn, a credit crisis and a deluge of overvalued,
unmarketable and quickly depreciating assets stuck on their balance
sheets. Their true economic performance is revealing such, but is
masked by clever, yet allowable accounting shenanigans.
Morgan Stanley Write-down -2008 Level 1 Level 2 Level 3 Total
(In US$ mn)
instruments owned
government and agency securities
- 12 2 14
sovereign government obligations
- 9 0 9
and other debt
2 2,761 2,223 4,986
413 71 62 546
226 7,252 3,240 10,719
Investments 1 1 196 198
- 12 - 12
financial instruments owned
642 10,120 5,723 16,485

Published in BoomBustBlog
Monday, 16 June 2008 01:00

GE: The Uber Bank???

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 had this
on my desk for a while and forgot to post it and was reminded about it
when a sell side analyst downgraded GE this morning.

/* Style Definitions */
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Electric (GE)

Electric share price has declined 22% in the last six months


The General Electric share price has taken
significant beating in the last six months and has fallen 22% on account of its
exposure to the financial services business and currently trades at US$29.05
per share. GE’s share price declined almost 13% on 11 April 2008 as it reported
a significantly lower than anticipated 1Q 08 results. The share price has
fallen by almost 21% since the announcement of its 1Q 08 results.

Published in BoomBustBlog

This is a DRAFT of part 3 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment should be very illuminating to those who are not familiar with the CDS markets. I urge discourse, conversation and debate. To me, it is necessary to make sure the world is as I percieve it. The recent bear market rally took back a decent amount of the directional, unhedged profit (that's right, I'm a cowboy), but it appears that is over and we will soon resume our descent back into reality. Just in case, let's review some history. I will also release some of my personal bank short research to illustrate how I am implementing these expected stresses to the banking system to my advantage.

The Current US Credit Crisis: What went wrong?

  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. You are here =>The counterparty risk analyses – the counterparty failure will open up another Pandora’s box
  4. To be Published: The consumer finance sector risk is woefully unrecognized
  5. To be Published: An oveview of my personal Regional Bank short prospects
  6. To be Published: Credit rating agencies – an overhaul of the rating mechanism
  7. To be Published: US Federal reserve to the rescue

And now, on to the report...

Emergence and the extraordinary growth of the CDS market

Innovation in the financial services industry created the Credit Default Swap (CDS) market to allow banks to hedge their risk as well as speculate on the health of any company. The evolution of CDS from the time it was first introduced by JP Morgan’s Blythe Masters (Head of Derivatives Department) in 1995 has been exceptional. The CDS over the counter derivative market has grown from US$900 billion in 2000 to US$45 trillion in 2007, almost twice the size of the US equities markets. The US$45 trillion market value of CDS contracts has grown more than 10 times of US$5.7 trillion corporate bonds which it insures. The major players in the CDS market are the commercial banks as its business evolves around the credit risks on the loans its disburses to corporations. The CDS market allows banks (theoretically) to transfer risk without removing assets from its books and without involving the borrowers. Credit default swaps also help banks to diversify their portfolio and gain exposure to various industries and geographies.

Insurance companies and financial guarantors emerged as dominant players in the CDS markets as net sellers of credit insurance protection. Insurance companies and the financial guarantor industry are the big sellers of protection in the CDS market, with a net sold position of US$395 billion and US$355 billion, respectively at the end of 2006. In addition, global hedge funds have emerged as active players in the CDS market. According to Greenwich Associates, the hedge funds are responsible for driving nearly 60% of all the CDS trading volume and 33% of the Collateralized Debt Obligations (CDOs) trading volume.

CDS has emerged over the last few years as an important tool to manage credit risk and has allowed banks to offset risk from their lending and bond portfolios. CDS has similar risk profile to a corporate bond. However, unlike a corporate bond the CDS does not necessarily require an initial funding which helps to build leveraged positions. Credit default swaps also assist in entering into a transaction wherein the cash bond of the reference entity of particular maturity is not available. In addition, by buying credit insurance (protection) of any reference entity, it provides the investors an opportunity to create a short position in the reference entity. Consequently, CDS having all these unique feature evolved as an important tool to diversify or hedge one credit portfolio and even take a long or short call on any company.

The two important factors driving the growth in the CDS market has been the strong US economy growth post 2001 and the low interest rate environment which has allowed for refinancing opportunities for marginal borrowers and deals that may have gotten into serious trouble without such a low cost capital environment – both resulting in very few corporate defaults thus encouraging banks to underwrite more credit insurance. The banks found it to be an attractive and low risk method to make profits since the number of failures were relatively few as the economy was in strong shape. In addition, the advent of speculators in the credit insurance market was a key growth driver for the CDS market as these contracts provided an alternative to bet on the company’s health. These instruments provided speculators a means to take short or long positions depending on their analysis of the company’s future performance.

Functioning of the credit insurance market

In a CDS transaction, the buyer and the seller of credit insurance protection enter into a contract wherein the buyer pays a fixed premium for protection against a certain credit event such as a bankruptcy of the reference entity, or default on the debt issued by the reference entity. Generally, there is no exchange of money between the two parties when they enter into the contract, but they make payments during the term of the contract. The key terms in the contracts entered between the parties are:

Published in BoomBustBlog
Saturday, 19 April 2008 01:00

It ain't over...

From Fitch's latest report :

As the U.S. housing crisis continued to deepen in 2007, Fitch’s global
structured finance rating actions took a decidedly negative turn, driven
overwhelmingly by the unprecedented credit deterioration in the U.S.
subprime mortgage sector. By year’s end, U.S. subprime-related
downgrades affected 3,529 tranches, or 77% of the year’s 4,570 global
structured finance downgrades. Total downgrades readily topped upgrades
of 1,790, the first year in recent history to see such a trend in structured
finance. However, the nonmortgage ABS and CMBS sectors reported
more upgrades than downgrades in 2007.

The subprime mortgage sector downturn also pushed up the global
structured finance default rate in 2007 to 1.19% from 0.37% in 2006. The
average annual global structured finance default rate over the 17-year
period ending in 2007 subsequently moved up to 0.77% from 0.68% in

In reviewing 2007 global structured finance rating
activity, it is important to note that credit quality
continued to deteriorate in the subprime mortgage
and CDO sectors in early 2008, resulting in
additional and significant negative rating migration.

• Fitch’s global structured finance rating activity
turned net negative in 2007, with downgrades at
least 2.5 times more frequent than upgrades and
a record 14% of structured finance tranches
experiencing negative rating actions over the
course of the year, compared with 6%
experiencing positive rating actions. This
produced an upgrade-to-downgrade ratio of 0.39
to one in 2007, a stark contrast to the 4.54 to one
ratio reported in 2006.
• Despite weak performance in the U.S. subprime
mortgage securitization and CDO sectors, 80%
of global structured finance ratings remained the
same in 2007. However, this is down from an
85% stability rate in 2006.

Published in BoomBustBlog
Wednesday, 16 April 2008 01:00

Wall Street still doesn't get it.

From WSJ.com:

Some 10 months after the mortgage hurricane made landfall, Merrill Lynch & Co. is still trying to dig out.

On Thursday Merrill will report $6 billion to $8 billion in new write-downs, according to a person familiar with the matter. The latest would bring its total since October to more than $30 billion and mean that Merrill reports a third straight quarterly net loss, the longest losing streak in its 94-year history.

New chief executive John Thain has said that, having recently raised $12.8 billion in fresh capital, Merrill won't need to seek more in the foreseeable future. Mr. Thain has increased the importance of weekly risk-management meetings by requiring the heads of trading businesses to attend and by having the top risk managers report directly to him. Since taking over in December, he also has reduced executives' incentive to swing for the fences by tying more of their pay to the firm's overall results and less to how businesses do individually.

Yet as of year end, Merrill still appeared to be taking large risks. Its "leverage ratio" -- how many times assets exceed equity -- stood at 31.9 to 1, higher than most other Wall Street firms. Heavy borrowing like this magnifies both profits and losses.

This does not solve the problem, it just incentivizes star employees to jump ship when they overperform yet have their bonuses dragged down by those that don't. What you need to do is give them what they want. If everybody wants mini-fiefdoms, then they get it - all of it. Producers, bankers and traders should be individually responsible for risk AND reward. Currently, they get paid only for the rewards they produce, and the shareholder gets stuck holding the bag of risk - with most of the reward stripped out in the form of overly generous compensation.

In my entrepenerial financial pursuits, not only do I not have a regular and reliable salary, but I am fully responsible for risk and reward. Although I still take significant risks for a living, they are in no way (and never will be) outsized in relation to the commensurate reward. As a matter of fact, I won't even take a risk if the reward doesn't outstrip the risk. The risks that I take may seem large to the untrained eye, but they are actually small when taking the whole pie into consideration. The extreme volalitility that I faced head on with large directional bets are an example of such. I was short certain sectors of the market, and as volatility spiked, trash companies rallied hard and short covering ramped up I sold shorts and/or bought puts into these rallies. This resulted in my account showing much more volatility than the broad market averages and mutual or hedge fund indices, but at the end of the day the resultant profit easily outstrips all indices and averages by several multiples - even according to all of applicable risk adjusted measures. A quick perusal of my blog should confirm this in an indirect way.

I am able to discpline myself in the gorging of volatility and market risk because I am responsible for my own losses and have no one to lay them off on. If the bankers, traders, and sales persons of Wall Street had the same responsibilities, I am sure the genius in them will be able to produce similar results. If you read the entire article linked above, it appears to be spotted with many "managers" who were not compensated with risk adjusted return, just with return. Thus they pushed for imprudent risks. This is not the way to do it. Be entrepenurial.

Hey, Merrill, this individual investor is available for consulting if you need him.

Published in BoomBustBlog

Being that Lehman's common stock historical volatility is a tad shy of 201%, implying a significant risk premium, are preferred buyers of Lehman stock being adequately compensated for the risk they are taking at 7.25%? Let's hear the quants weigh in.

Published in BoomBustBlog