Dear Temasek shareholder
Did you know that, at the current state of play, several investment banks are technically insolvent the moment they disclose their true financial situation? And that the U.S. Federal Reserve, the European Central Bank (ECB) and the Bank for International Settlements (BIS) are trying their best to prevent such a blowup from occurring, including lending unlimited amounts of money to these banks? Are you aware that the international press is clueless or does not wish to write about what is really going on within the investment banks, much less how structured products are priced, valued and traded? Why do you think that no person, entity or government corporation in the U.S., Europe, or the Asia-Pacific (other than yourself) wanted to touch the shares in these investment banks with a ten foot pole?
According to banking regulators, there are three kinds of assets in the world:
Level One assets are actively traded. You can know exactly how much they’re worth based simply on their price in the open market. Examples of Level One assets are common stock, bonds and funds.
Level Two assets are not actively traded. But they’re similar enough to actively traded assets to give you a reasonable estimate of their value. Examples of Level Two assets are preference shares, antiques and paintings.
Level Three assets are the most slippery. In addition to having no active market, they’re so unique, there’s no reliable way to estimate their true value. Instead, all that banks and regulators can do is guess. And the only tools they have to support their guesswork are unproven mathematical formulas. Examples of Level Three assets are structured products like credit derivatives, collateralised debt obligations (CDOs) and credit default swaps (CDS).
Here’s the key:
The money panic brewing today is driven largely by this third kind of asset — derivatives of questionable value that were artificially created by Wall Street brokers, officially sanctioned by Washington regulators, and falsely rated by Wall Street rating agencies.
These are the sinking assets that are hitting the big Wall Street firms … panicking investors all across the U.S. and Europe … even threatening some money market funds.
Some of Wall Street’s investment banks have more Level Three Assets than they have capital
Specifically, according to data compiled by the Financial Times:
Merrill Lynch has US$27.2 billion in Level Three assets, the equivalent of 70% of its stockholders’ equity. In other words, for each $1 of its capital, Merrill has 70 cents in assets of questionable and uncertain value.
Goldman Sachs has US$51 billion in Level Three assets, or 130% of its equity.
Bear Stearns has sunk its balance sheet even deeper into the Level Three asset hole, with US$20.2 billion, or 155% of its equity.
Lehman Brothers is in a similar situation — US$34.7 billion, or 160% of its equity. And …
Morgan Stanley tops them all with US$88.2 billion in Level Three assets, or 250% of its capital. That’s an unwieldy $2.50 cents in Level Three assets for each dollar of capital. It implies that, in the absence of new capital infusions, all it would take is a 40% loss — and Morgan Stanley’s capital could be 100% wiped out.
Bottom line: The huge Wall Street write-downs you’ve heard about to date — among the largest in history — could be just the tip of the iceberg.
All told, there are 968 U.S. commercial banks that invest in derivatives. But among them, 963 banks hold a meager 1.5% of all the interest-rate and credit derivatives in America.
In contrast, just five banks hold an amazingly large 98.5% of all the interest-rate and credit derivatives.
That is why no one in the entire world, other than Qatar, Saudi Arabia and Temasek wanted to become shareholders of UBS or Merrill Lynch! Why would international IBs have to turn up, cap in hand, at the doorsteps of little red dot sovereign funds?
Helping to cut through some of the uncertainty, the Office of the Comptroller of the Currency (OCC) evaluates the credit exposure of each U.S. bank holding derivatives. In other words, it asks the question:
Regardless of whether the bet is a win or a loss, what happens if the investor on the other side of the bet doesn’t pay up?
In normal times, such payment defaults are rare. So this is largely a theoretical question. But in a money panic, when markets can go haywire and available cash financing can suddenly dry up, a chain reaction of defaults could make this a very urgent and practical question. The answers, according to OCC data are that overall, including all types of derivatives:
Wachovia has credit exposure that’s equivalent to 89% of its capital. In other words, if all of its counterparties defaulted on their bets with Wachovia, nearly nine-tenths of its capital would be wiped out.
Bank of America is exposed to the tune of 99% of its capital. Assuming no capital infusions, it could be virtually wiped out in an extreme money panic scenario.
And at three banks, the panic would not have to be quite that extreme:
Citibank has 292% of its capital exposed to this kind of credit risk.
JPMorgan Chase has 387% of its capital exposed.
HSBC beats them all with an exposure of 388% of its capital. That means that even if its counterparties defaulted on just 26% of their bets, its capital could be wiped out.
Now, remember what I told you about Level Three assets — that they don’t have a regular place to trade.
Well, we could say something similar about the overwhelming majority of derivatives: They are not traded on regulated exchanges. Rather, they are traded over the counter, based on individually negotiated contracts.
In other words, if there’s a default, the parties have to work through it directly, one on one. Exchange authorities are not going to step in to help manage the crisis for them.
And currently, four of the five U.S. banks I named earlier trade over 90% of their derivatives in this way — outside of regulated exchanges.
At JPMorgan Chase, Bank of America, Citibank and HSBC, the derivatives they trade outside of exchanges represent 94%, 93%, 97% and 97% of their total, respectively. Only Wachovia has a somewhat lesser amount in this category — 77%.
What does this mean?
That the upcoming financial collapse will be the worst of its kind in human history, and will make 1929 “look like a walk in the park”.
Ah, but you say, ML and UBS are fine. They are immune. They are in a different class altogether. You have spoken to their finance departments, their auditors have produced interim reports. No problem at all.
Well, two points:
1. It is not in the interests of the vendor of an asset (and neither is it under any obligation) to inform you that it’s asset is worthless, or even worse, a liability (aka, caveat emptor).
2. If it’s too good to be true, it usually is.