How big is TOO BIG (to fail)?

"Too big to Fail"

"Too big to Fail"

"Too big to Fail"

We've been hearing a lot about this bank being too big to fail, or that bank (or GSE or commercial bank or investment bank or insurance company or hedge fund or money market fund or... central bank or... deposit insurance corporation or...) but what does that mean?  Yes yes yes, systemic risk etc, but Nemo over at newly-discovered (to me) self evident has done a bit (a lot) of work to find out at least what scale of bigness we're dealing with these days.  Read the posts here: Part 1, Part 2 & Part 3 but for example, here's what he (/she?) writes about Merrill, AIG and LTCM:

Merrill Lynch has $966 billion in assets and $931 billion in liabilities.  They are counterparty to $4.2 trillion in derivatives trades.   They get brownie points for including HTML anchors in their 10-Q.  (Do we still use the phrase “brownie points” after Katrina?)

AIG (10-Q) has $1.0 trillion in assets (10-Q page 1) and $972 billion in liabilities (page 2). They are counterparty to at least $447 billion in credit default swaps (page 87).  But that does not include the old-fashioned insurance operations, and who knows what else because I am tired of slogging through this stuff.  Executive summary: What would happen if an insurer with $1 trillion in assets were to fail?  I have no idea; and neither, I suspect, does anyone else.

In 1998, Long-Term Capital Management nearly collapsed.  They had $129 billion in assets and $124 billion in liabilities.  But the real problem was that they were counterparty to $1.25 trillion in derivatives trades.  Because their collapse might have created a chain-reaction throughout the financial system, then-President of the NY Fed William McDonough called together the heads of the major commercial banks and investment banks and politely asked them to cooperate.  The banks bailed out LTCM without any government backstop.  (Bear Stearns declined to participate in the bail-out, a fact never forgotten by its peers.)

Great stuff.  Scary reading.

(Just updated my blogrollthing at left)

=========

"You've Got The Fed" (from Versus Plus)

.

::

Rewind to Sept 12th, 2007, Lehman Bros says: BUY AIG

Well, yes yes yes, I know this is unfair, but a year ago we had some inkling that it was all getting kinda ugly, hadn't we?  Not at all THIS bad, but...

Lehman writes (on page 2) that AIG:

"... believes the downturn in the U.S. housing market should not be material to its investment portfolio and overall financial position. Although 62% of the company’s $29 billion in subprime RMBS investments are from the 2006 and 2007 vintage years, we are comforted that roughly all is AAA or AA rated. As a result, a substantial cushion exists before AIG would incur losses. For example, AIG estimates 40%–60% default rates would need to occur before the AAA and AA tranches are affected."

Sounds reasonable.  (If you trust the rating agencies.)

Upside of 25% to the $80.00 12-month target price, here we come!  (Last traded aftermarket on the 16th at $2.60, following which the Fed's takeover, about 30% off the Tuesday NYSE close... and 97% lower than Lehman's target for September 2008.)

.

Stumble It!
::

::

A(Drexel) I(Burnham) G(Lambert)

Investment bank Drexel Burnham Lambert lives on (in a very Drexel Burnham Lambert sort of way, actually,) in AIG's increasingly famous AIG Financial Products unit...

Michael ("Not Lewis") Lewitt, started his Op-Ed column in the NYTimes on Monday by recalling that day in February 1990 when Drexel, his shop at the time, folded.

"At the time, Drexel had $3.5 billion in assets and was the biggest underwriter of junk bonds..."

That was, of course, the last major investment bank to truly fold and file for bankruptcy protection (rather than get merged, rescued, bought out etc) prior to Lehman Bros.  He then pointed out, for colour, that at the time that Lehman folded, 

"Lehman owned more than $600 billion in assets. Financial institutions around the world have already reported more than half a trillion dollars of mortgage-related losses and that figure will most likely double or triple before the crisis exhausts itself."

Then on to the (still confusing) wonder that is AIG:

"But there is a bigger potential failure lurking: the American International Group, the insurance giant. It poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds... There is (a) substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. A side effect: Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression... A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated, Brobdingnagian credit default swap market that is reported to be at least $60 trillion in size."

And so on to the FT this morning... 

"As American International Group fights for survival, the question on everyone’s lips is how could what was once the world’s biggest insurer get itself into such a mess? The answer has its roots in a decision in the late 1980s to hire a group of derivatives specialists from Drexel Burnham Lambert.  These formed the basis of AIG Financial Products, which wrote billions of dollars of derivatives, which are now at the heart of AIG’s woes and are a long way from the mainstream insurance business that continues to lie at AIG’s core."

(See article from 1990 here.)

Where will the ex-Drexel team go next, I wonder?  

Actually, they are now virtually employed by the Federal Reserve, aren't they...??!!!

=============

Maybe more circularity some time in the (not-too?) distant future??

• AIG (founded in Shanghai in 1919 by an American) - market cap, based on after-market trading price: USD700m
  
• China Life (HQ in Beijing) - market cap based on yesterday's ADR close: USD84,700m
  

Well, you never know what the Fed may eventually want to do with its stake...!

.
Stumble It!
::

::

AIG post-cuts... still Investment Grade... for now...

NEW YORK, Sept. 15 /PRNewswire/ -- Standard & Poor's Ratings Services said today that it lowered its long-term counterparty rating on American International Group Inc. (NYSE: AIG) to 'A-' from 'AA-' and its short-term counterparty credit rating on AIG to 'A-2' from 'A-1+'...

New York, September 15, 2008 -- Moody's Investors Service has downgraded the senior unsecured debt rating of American International Group, Inc. (NYSE: AIG) to A2 from Aa3 in light of the continuing deterioration in the US housing market and the consequent impact on the group's liquidity and capital position due to its related investment and derivative exposures. The company's long-term and Prime-1 short-term ratings were placed on review for possible further downgrade...

CHICAGO--(BUSINESS WIRE)--September 15, 2008

Fitch Ratings has downgraded the Issuer Default Rating (IDR) and outstanding debt ratings of American International Group, Inc. (AIG) as follows:

   --Long-term IDR to 'A' from 'AA-';

   --Senior unsecured debt to 'A' from 'AA-'.

   --Short-term IDR to 'F1' from 'F1+';

   --Commercial paper program to 'F1' from 'F1+'.

   Fitch has also downgraded AIG's holding company and subsidiary debt and insurer financial strength (IFS) ratings. A full list of rating actions is detailed below. The ratings also remain on Rating Watch Negative by Fitch.

Moody's S & P Investment Grade Ratings Aaa Aa A Baa AAA AA A BBB Below Investment Grade ("Junk Bond") Ba B Caa Ca C BB B CCC CC C In Default   D

http://www.moneychimp.com/glossary/investment_grade.htm

Long-Term Credit Ratings

Fitch's long-term credit ratings are set up along a scale from 'AAA' to 'D', first introduced in 1924 and later adopted and licensed by S&P. Moody's also uses a similar scale, but names the categories differently. Like S&P, Fitch also uses intermediate modifiers for each category between AA and CCC (i.e., AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB- etc.).

Investment Grade

• AAA  : the best quality companies, reliable and stable
• AA  : quality companies, a bit higher risk than AAA
• A  : economic situation can affect finance
• BBB  : medium class companies, which are satisfactory at the moment

Non-Investment Grade (also known as junk bonds)

• BB  : more prone to changes in the economy
• B  : financial situation varies noticeably
• CCC  : currently vulnerable and dependent on favorable economic conditions to meet its commitments
• CC  : highly vulnerable, very speculative bonds
• C  : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
• D  : has defaulted on obligations and Fitch believes that it will generally default on most or all obligations
• NR  : not publicly rated

[edit]Short-Term Credit Ratings

Fitch's short-term ratings indicate the potential level of default within a 12-month period.

• F1+  : best quality grade, indicating exceptionally strong capacity of obligor to meet its financial commitment
• F1  : best quality grade, indicating strong capacity of obligor to meet its financial commitment
• F2  : good quality grade with satisfactory capacity of obligor to meet its financial commitment
• F3  : fair quality grade with adequate capacity of obligor to meet its financial commitment but near term adverse conditions could impact the obligor's commitments
• B  : of speculative nature and obligor has minimal capacity to meet its commitment and vulnerability to short term adverse changes in financial and economic conditions
• C  : possibility of default is high and the financial commitment of the obligor are dependent upon sustained, favourable business and economic conditions
• D  : the obligor is in default as it has failed on its financial commitments.

http://en.wikipedia.org/wiki/Fitch_Ratings

==============

And the amazing thing is this: We still live (and die) by what the rating agencies say.  Unbelievable.

.
Stumble It!
::

::

BofA (Charlotte, NC) & Merrill Lynch (NY, NY)

Who will be the CEO of the merged entity? BAC's Lewis or MER's Thain?

Conventional Yankee wisdom suggests Kenneth D Lewis, but perhaps down in th' Deep South, things are done differently, and John Thain may have a chance - if his banjo playing is up to scratch.

========

And as for poor old Lehman - see (and hear) Meredith Whitney's comments on CNBC from the start of last month here. 

.
Stumble It!
::

::

"Housing: Are We Near the Bottom?" (Nope.)

The always readable & thought-provoking (and free) John Mauldin is not bullish:  "Housing: Are We Near the Bottom?"

"By now, everyone in the world is aware of how bad the subprime mortgage business was. But now it is time to get ready to hear the same tale, told again, about Alt-A mortgages. These are mortgages made to borrowers with better credit scores than subprime borrowers, but who could not or decided not to document their income. One estimate is that 70% of Alt-A borrowers may have exaggerated their incomes (Wholesale Access). More than half of those were people who exaggerated their incomes by 50% or more! (Mortgage Asset Research Institute)

"How much are we talking about? Around 3 million US borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of subprime loans outstanding. $400 billion of that was sold in 2006. Almost 16% of securitized Alt-A loans issued since January 2006 are at least 60 days late. Many of these loans (around $270 billion) were interest-only or with a low teaser rate, and the resets were at 3- and 5-year lengths. These are called Option ARMs. That means starting next year we are going to see a wave of mortgages resetting to new rates. And it is no modest increase. Rates can jump 4-8% or more from teaser rates. Some Option ARMs are resetting at 12.25%. That can double a payment."

So how much worse will it get, and for how much longer can we expect to experience the pain?

"Burns (of www.realestateconsulting.com) thinks that home prices will drop by 22%, 12% of which has already occurred...  He thinks it will be 2011 before housing prices begin to turn back up on a nationwide basis, with national prices continuing to fall into 2010."

So there.  (And if you can actually find a buyer, now you know what to do...)

.
Stumble It!
::

::

Oh, The Horror of it All... er... getting priced in?!?!?!

So Credit Default Swaps are getting increasing airtime in Asia these days as a proxy for how %$#%-ed up our capital markets are out here, so I thought it would be interesting to see what they would tell us about where equity markets might be going, given that we've been seeing a sustained pickup in swap rates out here for the last 6 weeks or so.

Plotting the rolling 1 month % change in the MSCI Far East ex-Japan index against the Itraxx Asia Investment Grade index from JP Morgan (via BB) it actually looks like levels above about 150 on the index is a good flag for a correction in the equity markets in coming months.  (Short history, so obviously not statistically significant - and of course, it's just one factor etc.)  

At least, it was over the last year - THIS round, it looks like the equity markets have jumped the gun out here in Asia and... is it really possible... may have already priced in these and maybe even higher levels of credit market stress??

Shome mishtake, shurely?

.
Stumble It!
::

::

kuh-pich-uh-ley-shuh n?

ca·pit·u·la·tion     Audio Help   [kuh-pich-uh-ley-shuhn] Pronunciation Key - Show IPA Pronunciation

–noun

1.	the act of capitulating.

2.	the document containing the terms of a surrender.

3.	a list of the headings or main divisions of a subject; a summary or enumeration.

4.	Often, capitulations. a treaty or agreement by which subjects of one country residing or traveling in another are extended extraterritorial rights or special privileges, esp. such a treaty between a European country and the former Ottoman rulers of Turkey.

capitulation. Dictionary.com. Dictionary.com Unabridged (v 1.1). Random House, Inc.http://dictionary.reference.com/browse/capitulation (accessed: September 11, 2008).

=================

Or, in the words of my  Morgan Stanley broker: "PUKEFEST."

.
Stumble It!
::

::

Morgan and Morgan - sounding bullish (CSFB more mixed)

This morning we have Ken Landon of JP Morgan (or JP Landon as he'll rename it soon enough) out with a bullish call on the US economy and equities based on the direction of gold and the USD.

"In my opinion, the 6% decline in the dollar price of gold since Friday is an important signal of investors confidence in the monetary system of the United States despite the heavily bearish news of the past few days. This is a radical shift from the environment either of early this year or in May-June when renewed concerns about the financial system drove investors into commodities as hedges against inflation... 

USD - The DXY dollar index hit the highest level since early-September 2007 (i.e., before the Fed's rate-cutting cycle) and EUR/USD briefly fell below 1.40.... Back in Sept/Oct 2007, equities were generally rallying while the USD was selling off.  The dollar gave the correct signal because it anticipated the downturn in the economy and the rise in inflation. A year later in 2008, the situation is reversed. Equities are falling while the dollar is rallying. In my opinion, which I have expressed ad nauseum, the dollar is giving the correct signal once again."

(Note that he never uses "IMHO" when profferring his opinion.)

Your faithful Excel-meister here has, therefore, produced this 20 year monthly year-on-year chart, to illustrate his point:

I take his point, but I don't see it on the chart.

Meanwhile, the Asia strategist over at Morgan Stanley, Mal Wood, in a pretty good note today asks "How Close to a Trough?"  (Then he answers himself - pretty dahn close, mate.)

Conclusions: When compared to prior market cycles, Asia-Pac ex-Japan equities appear to be very close to a trough. Valuation is just 5% above average prior trough levels. Monetary policy is supportive. US home price declines appear to be slowing. Sentiment in Asia is depressed. The global leading indicators are around prior trough levels.

• Valuation 5% Above Trough Levels: The forward PE is 5% above the average trough level. The trailing PE is already there. A 2ppt moderation in headline inflation should lift valuation by 13%. Current PBV assumes a 21% decline in earnings, a slightly worse outcome than our bear case.
• Ultra-Easy Monetary Policy: The US Fed has been ultra-easy since April 2008. Real rates in core Asia are at 14-year lows.
  
• The US Home Price Declines Appear to Be Slowing: US homebuilding stocks are back to November 2007 levels. Home price declines appear to be moderating, although inventories remain elevated.
  
• Sentiment Is Depressed: Our Asia capitulation index is at low levels, while foreign investors have sold 56% of the funds they put into Asia Emerging Markets in the 2003-07 bull market.
  
• Economic Lead Indicators Are Around Trough Levels: Our G6 and OECD lead indicators are at levels consistent with prior cycle troughs. The US market usually troughs one month after the lead indicator troughs, and Asia follows suit.
• But, of Course, Risks Remain: US equity valuations remain well above trough levels, and credit spreads have yet to peak, reflective of the ongoing credit squeeze. An ongoing sharp US dollar rally could also prove disruptive to Asia.

IMHO, I think it's too early to call a medium term trough in Asian markets, though if you're looking more than 6-9 months out, current markets may provide OK entry levels.

============

Much more interesting over at Credit Suisse, where there's some hot two-on-one action going on with Asia-Pac/GEM strategist Sakthi Siva and Asian quant boffin Sophie Biro stepping into the eight-sided cage in a double team against CS's dapper global equity strategist Andrew Garthwaite.

Sakthi went to a buy in Asia in a note last Friday (Monday must've felt good!) when her Asian Six Factor Model hit the buy signal, with a backtested (since 1992) 100% 6-12 month success rate.  (It was 26% overvakued in October last year, and is now 25% undervalued.)  Meanwhile, Sophie has her quanty tactical indicators for September flashing BUY (after flashing a SELL in August) on falling volatility, oversold price technicals, yield ratios, her proprietary NJA 3-factor model and positive seasonality.

HOWEVER, though still with a small overweight in Asia ex-Japan, Andrew Garthwaite is clinging to his (teddy) bear position in a smart note issued on Monday saying (with, evidently lots of people listening) SELL INTO THE FANNIE/FREDDIE RALLY!!! (I added the exclamation marks.)  Thinking is that a) US house prices need to fall more and excess housing inv will take time to absorb, b) this is the 4th extraordinary measure - previous ones rally and fizzle, c) troughs usually happen after the nationalisation of bank NPLs, and d) the main problem this summer for the markets has been the extent of the European/ Japanese slo-mo train-wreck slide into recession.  (He's also pretty bearish on banks - basically, just don't buy yet, esp in developed markets.)

My leggy markets are getting tired.  (Should've stretched more.)

(PS As ever, if you don't have access to the broker research notes linked above, just ask me and I'll try to send you a copy.)

.
Stumble It!
::

::

FNM/FRE rescue? We must be "Truly up the..."

Not by coincidence, the band SQUEEZE came to mind this morning as the equity markets went stratospheric on open, and then continued to trade higher. 

And not too surprisingly, given the truly MASSIVE short base out there, we hear that most of the active buying today is from short covering... more interestingly, long trades (whether long onlies or fast money) are pretty sparse.  So either the market is going to be unanimously right, which would be a first, or the markets actually could squeeze higher.

I don't like the fundamentals out there, as you can tell from my previous posts (eg this one, and this one), but technically we could be seeing a market with... yes... legs (though I am a lot less comfortable than I was back in July!!!)

===========

Besides the basic problem with US housing markets and climbing unemployment (don't tell me it's a backward looking indicator), you have the credit worthiness of the Treasury on the line... so even if spreads DO come down, and there miraculously IS some kind of fresh demand for housing in the foreseeable future, a weakened USD /higher Treasury yields could undo all that.  Early trading in 10Y today not too encouraging...

Medium term?  IMHO, we're "Truly up the Junction..."

.

Stumble It!
::

::

Pair shaped, Part II

OK, it's been 31 Calendar days since my first few trades on Marketocracy.  (See: "It's all going Pair shaped!")

A few winners, a few losers, and a few fat fingered trades using a new (to me) system, and the long fund plus short fund are, combined, down 0.3% (-0.2% excluding the order entry errors).  

The MSCI Far East index (ie Asia less Japan and India, no Aus) over the same period is off 12.3% and the S&P500 is off 4.2%.  

Annualised (not too accurately, as it works on calendar days) we're looking at -3.8% (-2.0% ex-cockups) vs Asia at -147% and the S&P at -50%.  Not too bad, though I'd prefer to be up.  Will be more interesting to see how it all does as markets swing up.

Current positions, some on the way in, some on the way out, all paired but with some net long & some net short trade positions...

LONG: SINA / SNDA / PWRD / CHU / KTC / SCR / SNP / UMC / VISN / LPL / SPIL

SHORT: SNDA / NTES / CHL / SKM / KEP / PKX / CMED /SHI / TSM / FMCN / AUO / ASX

.
Stumble It!
::

::

US Unemployment high and rising... not good...

US unemployment in white, S&P500 index in yellow

Until unemployment clearly peaks, it's hard to see strong, sustained equity market performance form the US... not to mention any kind of surge in housing take-up (or even decline in inventory.)

.
Stumble It!
::

::

US houses... Gotta be cheap now, right?

With US home prices down close to 20% from its peak, you'd think there'd be more buyers sucked in, wouldn't you? After all, in equity space we're looking at 20% as the marker point for a bear market, and smart long term buyers should be coming in, right?

Unfortunately, you'd be wrong, as the repercussions of the credit crisis on bank balance sheets and tolerance for risk have led, particularly since the start of this year, to a startlingly sharp increase in mortgage rates.

Hence, affordability, which as recently as a year (or less) ago, had started to look pretty decent, has gone back to pretty difficult levels... and all that in the face of job uncertainty, higher prices for staples and wealth destruction... not to mention the shutting off of the home-equity-for-groceries-SUVs-and-LCD-TVs spigot.

(And, as Floyd Norris of the NYT points out, the number of Prime foreclosures has just surpassed Subprime ones.)

NOT a good sign for US consumption, and all those in Asia counting on a rebound (i.e. everybody.)

.
Stumble It!
::

::

Nothing new under the sun...

Reluctant as I am to say it, but maybe it's different this time? As you well know by now, I am pretty bearish on equity markets, but believe that the pain trade continues to be to the upside for the time being...

... but not because of this chart from Morgan Stanley, which I got this afternoon, which shows "the evolution of 3 bubbles - the Nikkei in the 1980's, the Nasdaq in the 1990's and China A-shares in this decade. The peak of each market has been aligned to coincide. According to this chart and if history is to be repeated, we could see a dead cat bounce of about 20% before the market resumes its fall of another 50%."

Quality broking.

.
Stumble It!
::

::

Earn less! Spend more!!

Once again, data coming out of the US look bleak. Admittedly, it's one month's data, but you have (nominal) July Personal Spending UP 0.2% MoM (survey +0.2%, prev month +0.6%) with Personal Income DOWN 0.7% MoM (survey -0.2%, prev month +0.1%)... and all this at a time when the PCE Deflator is crackling along at 4.5% annual pace (survey +4.5%, prev month +4.0%.)

Year on year, again in nominal terms, we have spending up 5.3% with income up 4.2%... applying the PCE Deflator to it, in real terms, Americans are STILL, even now, spending 0.8% MORE in real terms than the same period last year, while real income is DOWN 0.3%... and all this in the light of a growing number of home-owners hitting negative equity, not to mention market based wealth destruction.


(Consumer confidence, as measured by the U. of Michigan Confidence Index, also came in a bit higher than expected - corroborating evidence for the positive spending numbers.)

Seems to me that the stimulus checks and the decline from the oil price peak (about double the macro impact of the stimulus checks, by some reckoning) is buoying the US consumer... but this does not look sustainable beyond another datapoint or two, max - we're already hearing about cracks in retailspace as the stimulus checks all get spent.

And then after that... (whack!)

=================

And on the US GDP front, you had the 2Q coming in at 3.3%, ahead of expectations (2.7%) and way ahead of 1Q at 1.9%. Great...

... except that pretty much the sole driver was reported to be trade... so with the USD now UP from those heady (well, for Dollar bears anyway!) days (the USD index, DXY was down 4.5% from end Dec'07 to end 2Q08 alone, but is up 8.7% from the late April lows) AND the rest of the world now grinding slower, the prospects for US growth (and personal income) are not so hot for the rest of the year, IMHO.

So for those of you hoping for a continuing upswing in US growth, my advice to you is...

Stumble It!
::

::