The Derivative Endgame

I think the end game is for the remaining 9 banks with big derivative exposure -

Suntrust
PNC
Northern Trust
Keycorp
National City
US Bank
Regions
BB&T
Fifth Third

Is for them to be taken over by the large banks to which the Central Banks of the World are giving cash -

JPMorgan/Chase/Bear Stearns
Bank of America/Merrill Lynch/LaSalle
Citibank/Smith Barney
Wells Fargo/Wachovia
HSBC
Bank of New York/Mellon
RBS/Citizens
Mitsubishi/Morgan Stanley/Union Bank
UBS/Paine Webber
Barclays/Lehman Brothers
Deutsche Bank
Credit Suisse
Goldman Sachs

I’ve spent a lot of time letting my mind wander on this topic and I think this is the Grand Strategy.

The goal of the Fed is to move all of the credit derivative exposure into a handful of banks (about a dozen). Once they get the derivatives all gathered up, they are going to sit down with the banks and start figuring out how to zero out derivative positions.

Think of it like a giant game of “Go Fish”, where everybody shows their cards – “you have a two and a three? I have a two and a three. I’ll trade you a two for your three…”

But it will be “you have risk on Bank A’s Bonds? I bought the insurance from you on Bank A’s bonds. I have risk on Bank B’s bonds because you bought the insurance on Bank B from me. I’ll trade you my insurance on Bank A for your insurance on Bank B and we can zero out the risk of both positions.”

The Fed will make up the difference to make sure that both parties have no net economic loss from the removal of derivative risk from the system. The banks are being compelled to do this, because the only way they can win is to play and get the Fed to cover your losses.

So Step One is to consolidate all the derivatives into a manageable number of banks.
Step Two is to zero out derivative losses and gains across these banks.
Step Three should go something like this –

Once the banks have removed the easy leverage in Step 2, their risk will then be in their portfolios of loans.

Think about all the loans you have. Each one may be with a different bank – 1st Mortgage, 2nd Mortgage, HELOC, Car Loan A, Car Loan B, Credit Card A, Credit Card B, Student Loan, other consumer loans…

I think Step 3 is to have the banks rip apart all the securitized debt instruments they issued and then reconstruct the credit picture for each individual (very Orwellian). These banks will trade pieces amongst one another to allow each bank to own all the debts of one person. The bank will then have the capability to go to the individual and offer them a standard rate on all their debt, which will be low enough to allow them to pay off all their debts over the next 30 years.

The people will feel like they have been saved!
The banks will make a fortune!!
The taxpayer will bankroll the whole thing and get back half or less of all the money paid in.

Actually, the taxpayer won’t get anything but a $4 trillion bill, because you know damn well that whatever money the government gets back from the banks will be spent by the government and not returned to the tax payer or used to pay down the soon to be $12 trillion National Debt.

Let’s see how it plays out, but those are my thoughts.

My guess is that we rally beginning on or about October 21st and then sell off again at some point in Early 2009. That sell off will be the point when the 9 remaining banks are taken over by The Chosen Banks. I may have to start buying banks on that last round of consolidation. We will see.

I’d love some feedback on this. Post a reply or email me at nbcharts@yahoo.com

Final Lehman CDS Settlement on October 21

It is becoming clear to me what is going on with $700 billion TARP/Paulson Plan. It has nothing do with mortgages, “distressed assets”, home owners, small businesses, LIBOR, Treasury Yields, “Main Street” or any other canard the media tries to throw up.

What it is about is that governments are terrified that banks are overleveraged in derivatives. They see the settlement of the Lehman Brothers Credit Default Swaps (CDS) on October 21 as a potential back-breaker for the banking system. You can review the Lehman CDS pricing here –

http://nbcharts.blogspot.com/2008/10/lehman-cds-settlement-on-friday.html

The estimates are that the settlement of all Lehman CDS could cost $300 billion for the banks who wrote the insurance.

Here is a list of the 25 largest players in the Derivative Market. Lehman was #25! If the #25 going under costs $300 billion then what would happen if JPMorgan, with 3,250 times the exposure of Lehman were to go under?

http://www.occ.treas.gov/ftp/release/2008-115a.pdf

Look at how the money being given to banks will be disbursed –

$25 billion each to – JPMorgan (ranked #1), Bank of America (#2), Citibank (#3), Wells Fargo/Wachovia (#4)
$2.5 billion each to – Bank of New York (#6) and State Street (#7)

$10 billion each to – Goldman Sachs (Hank Paulson’s company) and Morgan Stanley

#5 HSBC is getting handed a big pile of money by the UK government

The entire process of bank consolidation the last 18 months has been designed to manage the impact of derivative losses on the banking system.

JPMorgan (#1) bought Bear Sterns (former #5 on the list), because they would have taken a $30 billion hit if Bear went under

Bank of America (#2) has now bought Merrill Lynch (# 18) and Lasalle (#22)
Wells Fargo (#6) bought Wachovia (#4) and the other bidder for Wachovia was Citibank (#3)

Bank of New York (#7) bought Mellon (#12)

RBS (#19) has been nationalize by the UK
Deutsche Bank (#24) has been bailed out by Germany
UBS (#23) will get some cash from Switzerland
Union Bank (#21) was bought by Mitsubishi – gee, that name sounds familiar…

This leaves but a few stragglers –
Suntrust (#9), PNC Financial (#10), Northern Trust (#11), Keycorp (#13), National City (#14), US Bank (#15), Regions Bank (#16), BB&T (#17) and Fifth Third (#20)

I am not sure whether or not they will survive, but my guess is that these banks will not be bought out at premiums.

Then there is that little company called AIG which wrote the most CDS insurance. The initial bailout for AIG was $87 billion. Then last week, the Fed announced another infusion of $25 billion. My guess is that the government is funding AIG to make sure that they are able to make good on the CDS insurance they wrote. If AIG did not pay, then I am all but certain that several banks and hedge funds would become insolvent and that would lead to more problems in the financial system.

No doubt Morgan and Goldman are being given the money to cover any losses sustained by the hedge funds with which they trade. I am not sure if the Fed gave the money to the other banks to help them cover CDS insurance they wrote, or to cover them if some of the banks which sold them CDS insurance will not be able to pay.

So October 21 is the key date. If things don’t blow up, then we may be okay for a while. I am going to operate under the assumption that the best buying opportunity will a retest of last week’s lows between now and October 21.