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September 16, 2008

I Won't Say I Told You So, Again
by Reggie Middleton

My warnings on Goldman Sachs, Morgan Stanley, and CDS have born fruit, by the bushels, for those who have heeded it. The Doo Doo 32 and commercial real estate shorts will be revisited soon, for they are in for a round of hell after this malaise. My industrial shorts will follow, as well as my lesser known real estate and finance services positions and research.

Goldman is down over $50 per share (from about $185 to $134) since I issued my warnings and forensic analysis. Many thought they were too connected to fall with the crowd. That is not a scientific approach to these markets. It's simple math, they are at extreme risk and trade at a significant premium. For those who are hesitant to subscribe to my proprietary research, this trade (off of a relatively small commitment) would have paid the professional subscription for several years, with plenty left over. We have been hitting on all cylinders with the investment banks. I expect the Goldman trade to be more profitable than the Bear Stearns trade where the research came out at about $105 or so and eventually warned that a long would make sense at $3 and it was bought at $10 (see More on the accuracy of this blog's research and Performance of This Site for historical details of much of the research performance). The market is starting to see Morgan Stanley as the bastion of risk that I see it as, and it is paying off. I'll assume that there is no need to comment on how we did with the Lehman research and forewarning.

Reference the Moody's and S&P downgrades of AIG to see how my multiple warnings of the risks the CDS markets will pose come to pass. Bloomberg - AIG's Ratings Lowered by S&P, Moody's, Threatening Efforts to Raise Funds:

American International Group Inc.'s credit ratings were downgraded by Standard & Poor's and Moody's Investors Service, threatening efforts to raise emergency funds to keep the company afloat...

AIG Chief Executive Officer Robert Willumstad has tried to raise cash to forestall debt-rating downgrades that could hobble the insurer. A ratings cut may have "a material adverse effect on AIG's liquidity" and trigger more than $13 billion in collateral calls from debt investors who bought swaps, the insurer said in an Aug. 6 filing.

Wall Street's biggest firms convened at the New York Fed for a fourth consecutive day, this time to discuss AIG, which sold the banks and other investors protection on $441 billion of fixed-income assets, including $57.8 billion in securities tied to subprime mortgages. AIG's shares plunged 61 percent today in New York trading.

"I don't know of a major bank that doesn't have some significant exposure to AIG," said Kenneth Lewis, chief executive officer of Bank of America Corp., in a CNBC interview. An AIG collapse would "be a much bigger problem than most that we've looked at." ...

Calling for Collateral

A downgrade of AIG's long-term senior debt ratings to A1 by Moody's and A+ by S&P would permit counterparties to make additional calls for up to approximately $13.3 billion of collateral, while a downgrade to A2 by Moody's, and to A by S&P would permit counterparties to call for approximately $1.2 billion of additional collateral, AIG said in the Aug. 6 filing.

"If either of Moody's or S&P downgraded AIG's ratings to A1 or A+, respectively, the estimated collateral call would be for up to approximately $10.5 billion, while a downgrade to A2 or A, respectively, by either of the two rating agencies would permit counterparties to call for up to approximately $1.1 billion of additional collateral," the filing said.

AIG has already posted $16.5 billion in collateral through July 31. A downgrade could also set off early termination of swaps with $4.6 billion in payments, AIG had said.

And to add injury to insult...

Last week, the U.S. Treasury seized Fannie Mae and Freddie Mac, the two biggest sources of funding for U.S. mortgages, wiping out most of the value of their shares. AIG had $550 million to $600 million of preferred shares in the companies, said a person who declined to be identified because the insurer hadn't made a formal announcement.

Hurricane Ike, which struck Texas Sept. 13, may also pressure AIG, costing insurers $6 billion to $18 billion, the most since the record storm season of 2005, according to firms that specialize in gauging the effects of disasters.

The one-two punch of Lehman bankruptcy and AIG downgrades and potential bankruptcies stand to tear a big one in the fabric of today's global financial fabric. I have harped on this CDS risk incessantly, and now - here we are. I hope you are prepared... Bear with me as I rerun this content from a previous post, I am about to come round robin on a point made 2 months ago regarding a certain prominent global bank (notice the red emphasis)...

Counterparty risk exposure of various commercial and investment banks

The credit insurance CDS market is generally bought and sold over the counter making it difficult to exactly grasp the depth of the markets. Moreover, the parties involved in the transactions are not disclosed making it impossible for any lay man to measure the amount of risk transferred and who bears it. However, the Office of the Comptroller of Currency (OCC) Quarterly Report on Bank Trading and Derivatives Activities provides an insight into the credit derivatives market.

According to the OCC, banks witnessed trading losses to the tune of US$9.97 billion in 4Q 2007 as compared to trading income of US$2.3 billon in 3Q 2007 and US$3.9 billion in 4Q 2006. This loss, the first ever quarterly trading loss for the banking industry as a whole, is attributable to weak trading results, and reflects unprecedented turmoil in the markets, particularly for credit trading.

Top 25 commercial banks and trust companies in derivatives
(as of 31 December 2007)

RANK	BANK NAME	TOTAL ASSETS	TOTAL CREDIT DERVATIVES	Total credit derivatives bought	Total credit derivative sold	Credit derivatives as a % of Total assets	Bought credit derivative as a % of total assets
1	JPMORGAN CHASE BANK NA	1,318,888	7,900,570	4,033,869	3,866,701	599%	306%
2	CITIBANK NATIONAL ASSN	1,251,715	3,161,349	1,633,975	1,527,374	253%	131%
3	BANK OF AMERICA NA	1,312,794	1,612,676	1,505,763	106,914	123%	115%
4	WACHOVIA BANK NATIONAL ASSN	653,269	419,495	208,884	210,611	64%	32%
5	HSBC BANK USA NATIONAL ASSN	184,492	1,252,423	602,180	650,243	679%	326%
6	WELLS FARGO BANK NA	467,861	2,766	1,880	886	1%	0%
7	BANK OF NEW YORK	115,672	2,261	2,259	2	2%	2%
8	STATE STREET BANK&TRUST CO	134,002	238	238	0	0%	0%
9	SUNTRUST BANK	175,108	1,177	819	358	1%	0%
10	PNC BANK NATIONAL ASSN	124,782	6,056	3,956	2,100	5%	3%
11	MELLON BANK NATIONAL ASSN	39,674	0	0	0	0%	0%
12	NORTHERN TRUST CO	58,398	279	279	0	0%	0%
13	KEYBANK NATIONAL ASSN	95,862	8,100	4,347	3,753	8%	5%
14	NATIONAL CITY BANK	138,755	2,238	1,385	854	2%	1%
15	U S BANK NATIONAL ASSN	232,760	1,054	425	628	0%	0%
16	MERRILL LYNCH BANK USA	78,052	8,728	8,728	0	11%	11%
17	RBS CITIZENS NATIONAL ASSN	128,863	241	219	23	0%	0%
18	REGIONS BANK	137,050	202	72	130	0%	0%
19	LASALLE BANK NATIONAL ASSN	74,424	2,255	709	1,546	3%	1%
20	BRANCH BANKING&TRUST CO	127,698	182	10	172	0%	0%
21	FIFTH THIRD BANK	61,463	237	68	168	0%	0%
22	FIRST TENNESSEE BANK NA	36,726	0	0	0	0%	0%
23	UNION BANK OF CALIFORNIA NA	55,157	0	0	0	0%	0%
24	DEUTSCHE BANK TR CO AMERICAS	35,425	5,101	5,101	0	14%	14%
25	LEHMAN BROTHERS COML BK	5,834	0	0	0	0%	0%

Source: OCC fourth quarter bank trading and derivative activity report

JP Morgan Chase, Citibank and Bank of America have the largest credit derivative exposure followed by HSBC bank and Wachovia Bank. Considering only the credit derivatives bought positions of the various banks, HSBC bank and JP Morgan Chase credit derivative exposure as a percentage of total assets is significantly higher at 326% and 306%, respectively.

Now, as excerpted from my proprietary HSBC research report:

HSBC - a major player in the credit derivatives market

HSBC is among the top six players in the US$62 trillion credit derivative market. We believe the delinquency cycle, which is just beginning to truly deteriorate, would result in increased corporate defaults in the near future. The CDS market is already troubled by monolines, which are counterparty to a large number of transactions, going bust - The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! and Reggie Middleton says the CDS market represents a "Clear and Present Danger"!. Moreover, due to the complex nature of the CDS market, it is yet to be seen as to who will ultimately be the worst hit if corporate defaults continue to rise.

HSBC has a US$1.6 billion net exposure toward derivative contracts entered directly with monoline insurers. According to the bank, notional exposure toward credit derivative contracts totaled up to US$1.89 trillion as of December 31, 2007. Credit derivative assets on HSBC's balance sheet increased to US$25 billion in 2H 07 from US$4.4 billion in 1H 06. Considering the complexities in the credit derivatives market, we remain concerned as the unfolding of the CDS market story may seriously affect the bank's financial health.

Credit derivatives (notional amount outstanding in US$ billion)

Source: Company data

We have already covered the CDS market in detail in the Asset Securitization Series which talks about the potential losses that the financial markets could be subject to if a big counterparty fails.

Boombustblog subscribers can download the HSBC report to see what else I had to say (a lot), including valuation. Retail subscribers can get the summary here - HSBC_Holdings_Report_04August2008 - retail (87.28 kB), while professional subscribers can get the whole enchilada here - HSBC_Holdings_Report_04August2008 - pro (138.89 kB).

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

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