Monday, November 7, 2011

What you need to know about the financial sector and thus the market

We could be talking about a lot of banks, but in this post we'll deal exclusively with US banks and financial institutions. MF Global is kind of the canary in the coal mine. John Corzine who took over the 200 year old commodities and derivatives broker decided (I assume) that he longed for the days of being an investment banker and started to transform the 200 year old model in to something more resembling an investment bank. He took positions in European sovereign debt and lost, when they realized the ship was going down, they went looking for a buyer (this all happened very quickly), Interactive Brokers was originally interested, but MF wouldn't turn over the balance sheet of the company for 1 very good reason, they were breaking the law by using customer's margin to meet their own margin calls on their failing positions-BIG TIME ILLEGAL and this is why MF Global customers are having to put up new margin money because theirs is gone.

There are a few lessons here, one is that the risk to EU sovereign debt is enormous, the EFSF that needs to fill it's nearly empty box with $ ONE TRILLION DOLLARS will have a hard time, espeially as companies with exposure to this debt keep falling by the wayside. Just think about it in very basic terms, you can invest in XYX and get a guaranteed return of 2.5% or 4%, you can get a little more speculative and invest in some stocks and hope for better yields or someone can tell you that they have a filing business, it's failing so bad that some of its suppliers have already gone under. When asked if the situation is contained, the answer is "we think so, but we don't know for sure", so it could get a lot worse and this company that essentially needs $4 Trillion dollars to even give it a shot at survival wants you to give it a trillion dollars or somewhere thereabouts. You'd have to be crazy to invest in that, When you asked the owner if he/she has invested their own money, they say, "yeah, some", but you notice nice cars, jewelry, all kinds of things that they could put toward saving the company, yet they are unwilling to, however they still want you to believe that it's a good deal for you.

That is the EFSF in a nutshell. Germany won't put their reserves or gold in to the box, Greece is the parts dealer that has already gone under and as far as the situation being contained, Italy is the wild card. It's a plan that is on par with the 3-4 days they took to put it together.

The second lesson we might take away from this is, "THIS IS THE NEW SUBPRIME MORTGAGE EXPOSURE FOR US BANKS".  MF Global is the Bear Stearns less the happy ending and banks know this. Yes, smart money can be wrong, they were during subprime, they are with EU debt.

So we want to look for candidates that may become the next Lehman, I mentioned Barclay's, but there have to be hundreds.

It turns out that Morgan Stanley (MS) is another and they are realizing what bad investments these are, MS just released their 10-Q and did something along the lines of Austria's mega bank, ERSTE. They took EU debt exposure and moved it from level 1 assets to level 2 assets.

Level 1 assets are liquid assets that are traded (for instance-a share of MSFT). Anyone can look at the close and determine the value of MSFT. Well the same goes for EU debt, it is liquid, it is traded and its prices are well known. So at level 1 the value of the asset is "marked to market" or the current price.

Level 2 assets are less liquid, less traded and they don't have a market price. There's room for interpretation in determining the value of these assets by way of models.

Level 3 assets are far worse and leave a LOT of room for interpretation and that's what made subprime so bad.

However the point being that Morgan Stanley just pulled a fast one to reduce the visible exposure they have to EU debt.

This from their own just released 10-Q


"Financial instruments owned—Other sovereign government obligations.    During the quarter ended September 30, 2011, the Company reclassified approximately $1.8 billion of other sovereign government obligations assets and approximately $2.1 billion of other sovereign government obligations liabilities from Level 1 to Level 2. These reclassifications primarily related to European peripheral government bonds as transactions in these securities did not occur with sufficient frequency and volume to constitute an active."

First, it's intellectually dishonest to reclassify these from a market to market to a mark to model based on the excuse that they didn't trade actively enough to be able to mark to market. This debt trades every single day, to say it wasn't active should be criminal.

Essentially they reclassified the values from market to what is probably loser to par (what the face value is, not the market value). There's a huge discrepancy between the two that could run as high as a 65% loss that is hidden simply by reclassifying it.

This is essentially how ERSTE hid all of their sovereign debt and CDS, by saying it wasn't in a trading account and therefore not subject to disclosure during the bank stress tests and the scariest thing is that ERSTE is only 1 bank out of hundreds that could have done the same thing, yet the EU in all of their collective wisdom, still doesn't know who has what exposure and they won't know until either defaults occur or banks start failing and come begging for money. By that time, $4 Trillion dollars won't be enough.

I know all of this sounds very bearishly slant, but reality is not reality, it's usually FAR worse then what you are led to believe. I would honestly say there's about a 1-2% chance that this works out for Europe without something much worse then 2007-2008 occurring within the next 6-8 months. 

The thing  fear most is that people have become so indoctrinated with the "kick the can down the road" policies of the last 3 years that they can't recognize the changes that are occurring right now. IT was only 6 months ago that the motto was "Buy the dip" as the market participants thought we could just keep kicking the can down the road, but if you look at the last 3 FOMC meetings as well as Jackson Hole, it should be clear that the F_E_D has run out of ways to kick the can down the road.

When you look at Europe and you take in the EFSF leveraging plan (for me it was obvious the minute I read the release) it's like looking at the Kubler-Ross model

1) Denial (you may not recall, but we heard a lot of denial, a lot of rhetoric about how the EU single currency bloc will NOT be allowed to fail; we heard how Greece had a plan and they were moving toward solvency to only need a second bailout 6 months after the first)

2) Anger -This has been evident among the citizens of Europe for some time, how many riots and protests have we seen. Now it's evident at the political level. The first night of Finance Minister meetings held on a Sunday, the reports were that the German were telling everyone how things could have been resolved if the EU listened to them 6 month ago, it was reported that there was so much screaming and yelling that the orchestra preparing to play the EU anthem could hear it in a different section of the building. Merkozy's statement at the G-20 which may have been the biggest mistake  (so far as getting investors in the EFSF) was to tell the G 20 that any country could leave at anytime, thereby making EFSF risk a total unknown. For example, if Greece left and re-issued the drachma, all of those Greek bonds that are out there would be worthless. 

3) Bargaining- I'd say we are in end stage 2 and stage 3 right now. The EFSF plan alone was a pathetic ploy to appease the G 20, it wasn't thought out. The EU looks like a beggar roaming the world with an empty cup- China, Brazil, the G 20, the IMF, etc.

4) Depression, I'm sure it's there.

5) Acceptance-I'm not sure this s politically feasible.

The point is, don't assume the status quo will carry on. I've showed you several posts that all show historical facts about where we are and how it's worked out. History may not repeat, but it does rhyme and a familiar tune is is back on the radio.

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