Observation: MBIA as insured securities and structures with minimal loss history and nearly no legal precedent in how to handle conflicts during losses and liquidations, on an underlying of that is going through the biggest correction/bust in the history of this country’s financial system.

Observation: MBIA now has competition from a better capitalized, cleaner, and arguably better managed competitor that is eating into its business at a rate as fast as 60 clients per day.

Observation: MBIA reinsures, and is reinsured by very small circle of entities whom concentrate very highly correlated risks using more than 80x leverage.

Observation: MBIA’s insurance of leveraged loans and junk bond CDOs has not surfaced yet, but I’m pretty sure its there.

Final Observation and Conclusion: S&P has just affirmed the highest credit rating available to this company. This is a damn shame! This does not confirm the creditworthiness of MBIA, it devalues the meaning and worth of the AAA moniker. Shame on you S&P.

This is post is primarily to document my assertions of self insurance by the banks in their alleged efforts to prop up the monoline (or should I say multilines?). Below you will find a chart with links that provide, in extreme detail, the insured holdings of a handful of banks and one homebuilder with a large mortgage operation (I do mean extreme detail, including asset name, CUSIP #, ratings by all major agencies, vintage, etc.). Let me add that I don’t know how much of this is actually bank inventory versus what was sold off, but my guess is that the banks got stuck with the vast majority of everything from the last year or so. In addition, most of the underwriting banks can get stuck with the stuff that was found to violate the agreed upon underwriting guidelines (which is potentially a lot) for a certain period, even if it was sold off. This is something that can sink the smaller equity base banks such as First Franklin.

This is $120 billion dollars right here, and it is nowhere near comprehensive. These are RMBS, CMBS, and a smattering of consumer finance ABS insured by MBIA and Ambac. I know everybody thinks that we may be coming to the end of the writedowns from real estate related devaulations, but if that is what everybody thinks then everybody is wrong. This bubble took at least 6 years to build, it is not going to dissipate in 1 year. We are about 50% through the subprime crisis, but since this problem was never a subprime issue to begin with, we have lot more to go. There are all of the other classes of mortgages, the commercial real estate market, which I went over in detail , there is the consumer finance markets (recession, anyone?), then the big grand daddy of them all, the leveraged loan, junk bond CDO and CDS market - crashing at a financial institution near you. I am 50% through a forensic analysis that will expose the junk bond CDOs held by monolines that will probably knock your socks off. Alas, I digress…

This credit problem and real asset bubble is a result of combining very cheap money with the lax, “other people’s money”, moral hazard to be had whenyou don’t need to be responsible for your own underwriting - otherwise known as the natural consequence of asset securitization. Why fret over due diligence when we’re just going to sell the stuff off. The following are a sampling of whose holding the bag…

The Partial Cost of Monoline ABS Failure

First Frankin appears to have significantly more exposure than equity (a lot more, so much so that it actually through my Excel charts out of whack): First Franklin Monoline ABS Inventory

This chart is using gross equity as reported, not tangible equity or foresnically scrubbed equity which is bound to be a lower number. For examples of how we use forensic analysis to reconstruct reported numbers and financial statements, see the Lennar and General Growth Properties (with conference call update ) analyses.

I am short Morgan Stanley and Bear Stearns, for the very same reasons that they are numbers one and two on this list (excluding Countrywide, whose short position was covered a while back, although I still have a bear position on WaMu). To see my take on these two banks, read my overview on the industry: Banks, Brokers, & Bullsh1+ part and Banks, Brokers, & Bullsh1+ part 2 then read or download the full analyses: “The Riskiest Bank on the Street” and “Is this the Breaking of the Bear?“.

A thorough forensic analysis of Goldman Sachs, Bear Stearns, Citigroup, Morgan Stanley, and Lehman Brothers has uncovered…

Last week, Morgan Stanley called Citibank the “short play of the year for 2008”. That is rather rare – an investment bank not only issuing a plainly worded sell recommendation, but an actual short recommendation? And on a fellow bank??? I read it and said, “Hmmm!” Morgan Stanley has some damn nerve calling another bank a short. They are the RISKIEST bank on the street. Let’s take a quick visual overview, and then let’s go over how I came to that conclusion.

In just about every major category of risk bloggable, Morgan Stanley leads the pack! Those who live in glass houses shouldn’t throw stones…

Quick Definitions:

Before we go on, let’s make sure we are all on the same page as to what is in this inflammatory graph I just posted. I know it may not be fun if you are not into GAAP, FAS, financial engineering, or any of that other sexy stuff - but if you think education is expensive (in terms of time), then you definitely wouldn’t want to try ignorance – especially if you buy banking and brokerage stocks. I’ll try to make it as funs as possible without offending anyone too much. The following asset classifications have been in the financial rags quite often lately.

FAS 157 Asset Classifications

Level 1 represent assets that have observable free market prices. An example would be a stock traded on the NYSE or NASDAQ.

Level 2 assets don’t have an observable price, but they are calculated/modeled using inputs that are based on assets with observable prices. An example could be a plain vanilla interest-rate swap whose components are observable data points such as the price of a 10-year Treasury bond. This can get very tricky, very quickly since the inputs are market based but the calculations/models can be highly subjective and quite theoretical. This is where the financial engineering of many banks can come back to bite them in the ass. Let’s take the example just mentioned, and turn it into swaption: A swaption is an option granting its owner the right, but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term “swaption” typically refers to options on interest rate swaps. This list can get more extensive and complicated: variance swap , barrier option, Quanto swaps, etc. In addition to getting complicated, they can get increasingly difficult to unwind. The kicker is, the more you need to unwind them in a crunch, the harder they are to unwind. Thus good times are good, but bad times can get very bad. This is what happened to Long Term Capital Management. LTCM had lots of leverage, lots of complicated instruments, and even more models (model risk, see below). The problem was that reality hit theory, and it hit it very hard. Don’t worry, funds and prop desks will not make those old mistakes again. There is a whole crop of new mistakes for us to make.

Okay, so what is the value of the swaption cum swap, or anything else mentioned above in a sharply trending market? What is the value of a portfolio of barrier options if the optionality portion is deeply out of the money? You don’t know the answers to these questions? Well, guess what? I bet the CEO of Citibank, Bear Stearns, Morgan Stanley and Goldman Sachs don’t know either. There are probably a lot of institutional counterparties (hey don’t GS and MS have large prime brokerage arms?) of the big banks who trade these things and corporate owners of these level 2 instruments that don’t know either. Thus, you are in good company. For those who don’t know, prime brokerage is the extremely lucrative business of being the full service broker to hedge funds. You know those unrated (as if that really means anything with Moody’s et. al.), unregulated investment pools who, through the prime brokerage arms of the big banks yield often unwieldy leverage of 20x or more… Much more. There many counterparties to these transactions that don’t have the capital to pay up in the case of an outlier even, ala LTCM. Hey, I have a hedge fund, so I am not the pot trying to call the kettle black, here. I am just trying to point out the amount of risk and exposure that sits on these balance sheets that are not picked up by the average investor. Level 2 assets pose much more of a liquidity risk and valuation liability than I have been reading about, and almost no one has harped on the counterparty credit risk we have in our financial system.

Theoretically, these esoteric level 2 assets should be moved into a level 3 category, but because they have observable market inputs they can be classified as level 2, and it appears as if they certainly are. Look at the bank chart above to see.

Level 3 is for assets where one or more of those inputs don’t have observable prices. This is group of assets that are no more than management’s best guesstimate. It literally is reliant on management estimates and opinions. I wish these banks would allow me to shift my assets into the level three category for the purposes of credit evaluation. I’ll take a 50 LTV cash out refinance loan on my house, because the dog house outback is worth $125 million, in my opinion J. Level 3 assets are measured using management’s opinion of value due to a lack significant unobservable inputs that could be used to plug into the valuation model used for level 2 assets above (and as we have pointed out, that in and of itself, can get pretty hairy). So, we have bullsh1t, that won’t fit into other bullsh1t (excuse me, financial models). In simpler, and far less crass words (for my more sensitive readers) - stuff that absolutely nobody wants to buy. If someone was willing to buy, and someone else was willing to sell, there would be a market and observable inputs in the form of a market price, right??? These unobservable inputs are actually quite observable; management just doesn’t like what they observed! That’s funny, isn’t it? Why don’t they ask me my opinion of the value? And while we’re at it, I don’t like what I observed in my brokerage account’s P&L statement the other day, so I am going to unobserve it (you know, consider it unobservable), and value it at $4,300 gazillionJ

Level 4 – This not in FAS 157 or any fancy accounting rule book. This is just where I will classify off balance sheet assets. Oh yeah, that’s right I can’t classify, value, or even identify them because they are off balance sheet. That is most likely the reason they are off balance sheet. It is here, in level 4 where most of the risk lies. Props go out to Vikram Pandit, the new CEO of Citibank for bringing the bullshit (SIVs) back to the balance sheet where it belonged in the first place. Everybody derided you the first 12 hours of your new position, but you did the right thing. Now its time for everyone else to follow suit.

When will the bullsh1t cease??? Well, it doesn’t cease here because we have more to review as represented in the introductory charts above.

Leverage explained

Morgan Stanley has about $35 billion in equity, but wields about $1,120 billion in assets. This means that the difference is leverage (or borrowed monies). This is the business model for the street, in general, but that doesn’t make it a good one, per se. Take MSs 34x leverage and apply it to the inherent leverage contained in the instruments it trades as well as the counterparties it deals with, and you have a recipe for disaster if the right sequence of events occur. For instance, looking into the exchange traded futures markets, you have the opportunity to more than quintuple your leverage, thus your return. But… is the risk worth the return? I mean, what is the risk adjusted reward here?

Go on to Banks, Brokers, & Bullsh1+ part 2

Counterparty risk – why isn’t this in the media? Don’t these guys read my blog:-)

All futures contracts offer extreme leverage over the physical commodity for which they represent a forward price. I will make a representative sampling of Morgan Stanley’s asset holdings to illustrate a point:

• US Government and agency securities 1,000:1
• Foreign currency $1 million:1
• Equity indices are 250:1
• real estate indices, the multiplier is $250:1
• 1 month LIBOR is 2,500:1
• Interest rate swaps are 10,000:1
• Gold 50:1
• Coffee 37,500:1

Now, Morgan Stanley has a large and lucrative prime brokerage business. This is the business where the banks provide infrastructure and research for hedge funds (wouldn’t it be funny if I got this research from Citibank or Morgan Stanley?) and loan them money on margin. They regularly give up to 20:1 margin to their good customers, with many customers receiving much more. They also enter into OTC arrangements with these clients, basically accepting credit risk (and market risk, hedged or unhedged) with the funds as a counterparty. These funds are not banks, and do not carry statutory capital requirements or minimum credit ratings. They are just pools of private capital. Hey, you know I’m cool with that. The issue is, how do you quantify the amount of credit risk assumed? Every bank does it differently. It is not standardized, and it possibly not even done very well. Nominally, as reported by MS, this counterparty exposure is 112% of capital. That is a lot. But wait!!!! Let’s look at the anatomy of a relationship.

Let’s assume the hedge fund x is offered average leverage of 20:1 by MS Prime Brokerage services. MS is now selling that leverage and accepting the credit risk of an unrated, unregulated buyer. {For the record, I am totally against rating and regulating hedge funds. If you read my blog, you know how I feel about the big rating agencies, and regulation will just drive capital offshore - for good - while making no improvement here in the states! The solution is tighter risk management in the banks and brokerages – this is a private affair!} MS is doing this with 34x leverage itself. The buyer then buys invests in a portfolio like the one listed above in the futures and OTC markets, etc. at an average of 500:1 leverage. The hedge fund is effectively utilizing it equity leveraged (500*20=10,000) 10,000x on the physical and financial underlyings to speculate (and/or hedge – yeah, right). If things go bad, ex. Subprime debt or quantitative trading model blow ups, small moves can result in 10,000x losses to the equity, and multiply the 10,000x times the equity of MS’s equity capital multiplier, and you can have a doozy of a spell. I know, it sounds quite apocalyptic and these are just round unhedged, anecdotal numbers, but I am sure at least somebody gets my point. Admittedely, this does NOT take into consideration hedging, nor does it take into consideration applied portfolio theory, diversification, correlation management, etc. and yada, yada, yada. What it does take into consideration is reality rarely quoted. What I am trying to accomplish here is an illustration of how dangerous excessive leverage can be.

Now, all we need to do is multiply this exposure by about 1,500 or so hedge funds/private clients and apply hedges that were implemented as skillfully as those in the subprime mortgage markets, and voila! Instant Morgan Stanley counterparty exposure.

Now, back to the banks…

So, now that we know what these levels 1 through 4 are, how leverage can help or hurt us equity investors, and the mystery of who loans to who and how risky it can be - how does this apply to the big banks? Well, here is a rundown of who has what and where.

Now, looking at the raw numbers can be misleading. As you may know, most financial institutions are highly leveraged. They make their money by deploying capital. The caveat is, not all of the capital deployed is really theirs. They borrow most of it. Equity capital is what I will define, for the sake of this blog, as capital that actually belongs to the institution (and thus shareholders). All other capital will be considered leverage, in some form of fashion. This is an oversimplification, but at the end of the day, this is what it boils down to.

I think Merrill has been much more forthcoming (not necessarily on purpose) than most of their competitors. The street will report more asset write downs, & they’re LEVERED UP! Here is a formula for a good short candidate: Asset write downs plus high leverage = Equity investors,”look out BELOW!” Why are O’Neil and Prince unemployed, yet the other CEO’s still working?

So, as you can see in chart above, Morgan Stanley is:

· The most leveraged on the street at about 34x equity deployed

· Has the most model risk of all of its peers here

· Has 2 and ½ more bullsh1t level 3 assets than the company they had the nerve to call the short of the year (don’t get me wrong, I’m short Citibank as well, but still…), and more than any other bank on the street

· Plenty of counterparty exposure, although they don’t lead the pack here

· And lead the pack reported (that’s the key word here) proportionate asset write downs to equity (I don’t know how long that will remain true though, I see many more impairments ahead).

A breakdown of MS’s assets, by class.

A close look at MS’s counter party credit ratings. Read the 104 basis points Halloween story in this blog for more on my take on ratings agencies. It will make you laugh.