10 October 2017

Whalen on CDOs, OBS, Fraud and Europe - I suggest you be very afraid

In 2006, after reading one of my friend Chris Whalen's articles in which he discussed the size and dangers of the Synthetic Collateralized Debt Obligation (CDO) market, I picked up the phone and rang him. "Chris, I have to admit that I simply do not understand what you've just written. Could you please explain it to me in small words?"

To his credit he did, and he took his time, and used small words, and at the end of our call, the only thing I could say was "Chris, based on what you've just taught me and what you are saying, you are now the scariest person I know."

Not long after came the collapse of Lehman Brothers and the slide into the Global Financial Crisis (GFC). Everything Chris had written seemed to come to fruition, as if he had written the play-book for the crisis, or at least the reasons for the processes creating the crisis.

Fast forward to 2017, and over the past two weeks Chris has again written two very alarming articles. Last week focusing on CDOs and OBS risk, while this week's article sheds light on why Europe should worry us.

Last week Chris wrote a piece, this time called "CDO Redux: Credit Spreads & Financial Fraud". Read this article from Chris. It is as scary as anything he wrote in 2006. Toward the end you'll find the following statement:
The fact that Citi, JPM and GS are now pushing back into the dangerous world of off-balance sheet (OBS) derivatives just illustrates the fact that the large banks cannot survive without cheating customers, creditors and shareholders.
He points out that the very largest banks, like retailers, cannot be profitable by selling a greater volume at a lose, but only by, in effect, cooking the books. This suggests that systemic fraud is part of the natural business cycle, and he seems to be saying that we are nearing the end of this cycle.
As we note in "Good Banks, Bad Banks," larger institutions suffer from a fatal lack of profitability that ultimately dooms them to commit fraud and, eventually, suffer a catastrophic systemic risk event.
How big is this problem? Chris has a nice chart. Sure, it looks like the problems were in the past, but look at the re-growth to today. Notional Off Balance-Sheet Derivatives (OBS) are, between the three largest (Citi, JPMorgan, and Goldman Sacks) over $140 Trillion, not far from the GFC peak of around $130 and a later peak of possibly $175 Trillion.

Now, I seem to remember that "OBS" - Off Balance-Sheet, is bad. I seem to remember that it was the Off Balance-Sheet manipulation via the use of Special Purpose Vehicles (SVPs) that distorted their true debt position, and lead to the crash of Enron in late 2001.

Imagine a bank for which a 30BP (Basis Points: 100 PB = 1%) move in the OBS book would wipe out the bank's capital. Imagine wiping out a bank's capital with a .07% move (7 basis points). Imagine any entity leveraged 8000:1.

Note too that the relatively small GS has a notional OBS derivatives book of more than $41 trillion, almost as large as that of Citi and JPM.  More alarming, a move of just 7bp in the smaller bank’s OBS derivatives exposures would wipe out the capital of Goldman’s subsidiary bank. This gives GS an effective leverage ratio vs its notional OBS derivatives exposures of 8,800 to 1.
Worried yet?

Jumping forward to this week, and he has nothing comforting to say about Europe (or again, the American situation). This the following is not a surprise, the clarity of statement leaves no doubt:

Zero rates and QE a la Yellen, Draghi and Abe is not about growth so much as it is about subsidizing debtors, especially governments and other public obligors who are beyond the point of recovery in terms of ability to repay debt.

Meanwhile we continue to see the Rape of Greece, with bailouts primarily intended to subsidize European banks and governments, with Germany seeming to take the lead. All this as European banks continue to record interest "income" against non-performing loans. Many of those loans will never be repaid, and a haircut is inevitable. Chris points out that "more public sector debt has been incurred and the banks – which admit to some €850 billion (6%) in non-performing loans – are essentially insolvent as a group."

The big question will be whether Cyprus becomes the model for Europe, and if so, how long can the banking sector survive a run, or at least a slow walk, on deposits by individual savers. So far, QE in Europe has been used to avoid this, but not forever.
Europe is drowning in debt and there are a number of large EU banks that are demonstrably insolvent.
This continued pretense by the Europeans, coupled with the CDO & OBS situation in the US points to two of the three major economic blocks (counting China & ROTW {Rest of the world} as the third) piling on higher and higher levels of systemic risk. And not matter what anyone says, it will not be different this time.

Chris is being scary again. and again, we should listen to him.


  1. Chris Whalen is generally ON THE MONEY.

  2. Daniel,
    The discussion is focusing on a silo called money. What about other values? Lets go into the world of thought games. I take the example I have always tried in the past. I assume Money is virtual. It only becomes real when I take cash and buy something. What does this mean:?
    1. If the entire world is in a debt mode, ie no country actually has any collateral, then we could hit reset. A little like in the past when we remove a few zeros from the bank notes.
    a. If this is true then the world would go on as normal (assuming we take the country with the lowest debt as the level playing field). This would still leave the finance group believing they are right and the problem would continue but be off set along the time line. Agreed some poor rich people will take a massive hit assuming governments don’t try to pass the buck to the tax payer. (I’m dreaming)
    b. If this is false (money does exist) then where is the money? If its in the hands of people rather than countries then this lead to another issue. As discussed in London in 2010 (I think) in the group “ What will risk management look like in 20 years?” it means that the world could be reorganised not in countries but in rich people domains. Ie a reset going back 1000 years or longer.
    2. If money is virtual then the concept of debt is questionable. The overriding assumption that the stock market is transparent is wrong. The whole calculation about shareprice is invalid. The current trend to stakeholder value, sustainability, values based on non-tangible assets such as image, reputation, honesty, trust comes to the forefront. Exactly as it should and as shown in the S&P study where 81% of a companies value today is based on non-tangible assets. If we look at the pricing of Facebook, the business model of Airbnb, Amazon, etc then value is not money or physical assets but image, reputation, honesty, trust as stated before.
    3. Greed is the virus killing humanity. Greed is however taken to be monetary in nature. Imagine we could redefine greed in terms of world peace, honesty, trust? Who would then be the richest people?
    Following our many discussions in the past concerning risk management I still believe:- If I remove the element of converting risk and opportunity into monetary terms then what is left is true value creation. These items, ideas, concepts need to be prioritised first and only then should I try to find a common denominator to compare. What is disturbing in the discussion is that the rich people will possibly not be hit as hard should something go wrong as the poor innocent people on the street.
    The issue I see is that even though the signals are clear many social systems are built around money and in order to change the path we are taking will require a massive dramatic and catastrophic change. The systems currently in place to do this, governments, politicians, large companies, rich people, etc won’t do this. You need an external force. Whats left is to decide which part of the wall we will run into at full speed.