Derivative Exposure Revisited

For background on this topic, you can review the following –

http://nbcharts.blogspot.com/2008/10/lehman-cds-settlement-on-october-21.html
http://nbcharts.blogspot.com/2008/10/derivative-endgame.html
http://nbcharts.blogspot.com/2008/10/updated-derivative-exposure-and-bank.html

Banks around the World have loaded up their Balance Sheets with Trillions of Dollars of Derivatives. The Derivatives they own are essentially Insurance Policies which they wrote on the Bonds issued by other Corporations or on the Assets that Banks “Securitized” (Mortgage Debt, Credit Card Debt, Student Loans, Home Equity Lines/Loans, Auto Loans…). They were designed to protect the owners of the Bonds in case of these bonds defaulted.

The Premiums charged on these Derivatives (Insurance Policies) were artificially low and the banks who wrote them wrote far too many, in an effort to increase their revenue and earnings (Congress was urged to allow this by none other that Hank Paulson when he ran Goldman Sachs and testified before Congress). These banks used massive leverage and Enron-like accounting tricks (off balance sheet entities like SIVs to hide losses) to allow themselves the ability to sell many times more insurance than they could afford to sell and still remain solvent, if the economy ever went into recession. So when the economy did slow and those Bonds did default, the Banks who wrote the Derivatives did not have enough capital to pay off all the insurance claims.

Here is a chart of the banks with the largest Derivative Exposure.
I have updated this list several times over the last few months. The bailout amounts are up to date as of tonight -

The game all along has been to corral the smaller banks with derivative exposure into the larger banks with derivative exposure. Once the derivatives were in the hands of a few players, these remaining banks would sit down with the Fed and cross their derivative and bond positions to try and remove as much risk out of the system they could.

My thesis has been that the TARP was created to make sure that the banks with massive Derivative Exposure had enough capital to cover the current claims as the Bonds they insured defaulted.

In Q4 2008, several banks on the list were merged and the remainder were given billions of capital via the TARP or were nationalized by the governments of their home countries. These banks were able to eliminate over $30 trillion in derivatives in Q4 2008.

Now those banks are again out of money and have gone bank to Washington to beg (and receive) the second half of the TARP. They were always insolvent, but they can no longer lie on their Quarterly Filings with the Government and now must be nationalized.

This has always been a slow motion nationalization of the banking system. The goal was to keep up investor “Confidence”, so that people didn’t panic and pull all of their funds out of insolvent banks and the debt of insolvent countries (US Treasuries) and insolvent states (California Municipal Bonds).

What they did was lie to the public to keep them buying stock. This allowed the over-leveraged Institutions in the know (Hedge Funds and Pensions Plans) to sell their over-priced crap to an unsuspecting Public. The Regulators have been on the side of the crooks and regulating the propaganda, because those in government believe that if they don’t prop up asset prices, then there will be riots in the streets. I’m not making this stuff up.

If you look at the list, then you can see that the banks to be nationalized are JP Morgan, Bank of America, Citigroup and Wells Fargo (Cramer’s “Fab Four” as I recall –propaganda). You will also notice on the list that Citigroup shows assets of $1.228 trillion, yet when they split up this week, they put $800 billion into one section and $1.1 trillion into the other.

That is a heck of a lot more in assets than they declared they held on their last Quarterly Filing (1.2 trillion versus 1.9 trillion). The excess assets were there all along, but they were held “off balance sheet”, so Citi was not forced to declare that they in fact owned them.

How about Barron’s telling readers to buy Northern Trust, State Street, JPMorgan and PNC last Sunday (1/11)? This week, the banking sector got creamed. Great call! Did they have some buddies who needed to blow out of some bank stocks ahead of last week’s bailouts? Disgusting. You either have an advocate on your side, or you get the heck out of this crooked stock market!

FASB
Do you remember late last year when FASB (Financial Accounting Standards Board) passed a proposal that would have to shut down all of the off balance sheet accounts at banks and force them to actually disclose all the assets they really owned (FAS 140)? Bank stocks started falling and Congressmen and US Treasury Officials begged FASB to repeal the ruling. The ruling was delayed until 2010. The banks continued lying and shareholders continued to see their stock portfolios fall in value.

British Banks are Insolvent
Royal Bank of Scotland (RBS) issue research declaring that the largest banks in Britain (RBS, HSBC, Barclays) are “technically insolvent”. So the UK Government has pledged yet another 200 Billion Pounds to toxic bonds off the balance sheets of British Banks (RBS, HSBC and the like).

http://www.nakedcapitalism.com/2009/01/british-banks-deemed-technically.html

Still pitting Taxpayer versus Shareholder
Citigroup will now split into 2 units – Citigroup and Citiholdings.
Citigroup will be the bank, with the $1.1 trillion of good assets that Citi presented in each Quarterly Filing as their only assets.

Citiholdings will hold the $800 billion in toxic crap formerly held off balance sheet. It will also hold the business units that Citi wants to sell – Smith Barney (what’s left), Foreign Banks, Consumer Finance and Asset Management.

That is the new model – Good Bank / Bad Bank. Look for Bank of America to duplicate the Citi breakup next quarter. Also look for JPMorgan and Wells Fargo to do the same. I would not be surprised to see foreign banks like UBS and HSBC do this in the next few weeks.

I do not know how shareholders will get anything out of this. The banks they own are insolvent and the government may not be very accommodating to their interests. Bond holders may also be forced to pay a hefty price for a bank rescue.

I will buy when somebody other than the Fed buys
So, the banks are still lying and the only buyer in town of anything with risk is the US Treasury and its surrogates. I will buy when big money shows up. Until then, this is just a history lesson playing out before my eyes.