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A Forensic View of a Wall Street Bank Balance Sheet Shows How Much Risk Rests In Its "Assets"

I'm here to dissect the balance sheet of Morgan Stanley and demonstrate the solutions that I've invented to proof against what I see is an upcoming, nigh guaranteed collapse. Before we get to that, we need to come to terms with counterparty risk and exactly what it entails. Also realize that Morgan Stanley is not unique in any way, balance sheet wise. What goes for MS can go for any money center bank on the street.

Now... Counterparty risk, more commonly known as a default risk in some circles, is a risk that a counterparty will not pay as obligated on a financial contract - including bonds, derivatives, insurance policies, repurchase agreements, etc. Parties to a transaction may attempt to hedge this risk via offsetting trades or credit insurance, but a true offset or perfect hedge is rarely possible and is usually (in reality) non-existent. In addition, hedges are usually the most useless when they're most needed due to issuess of liquidity, correlation, cross colateralization, rehypothecation, and macro/systemic disconnects.

Starting in 2007, I waived the counterparty risk flag for several financial institutions, nearly all of which collapsed within 3-6 months of my warnings - all having investment grade ratings and buy recommendations at the time of my warnings, by the way. Reference a sample of such warnings and the anecdotal notes that I pasted on about each:

Bear Stearns

The collapse of Bear Stearns in January 2008 (2 months before Bear Stearns fell, while trading in the $100s and still had buy ratings and investment grade AA or better from the ratings agencies): Is this the Breaking of the Bear? Notice the similarities between Bear Stearns in 2007 and Morgan Stanley today... Bear Stearns is below:

This is Morgan Stanley today...
Lehman Brothers
The warning of Lehman Brothers before anyone had a clue!!! (February through May 2008): Is Lehman really a lemming in disguise? Thursday, February 21st, 2008 | Web chatter on Lehman Brothers Sunday, March 16th, 2008 (It would appear that Lehman’s hedges are paying off for them. The have the most CMBS and RMBS as a percent of tangible equity on the street following BSC. The question is, “Can they monetize those hedges?”. I’m curious to see how the options on Lehman will be priced tomorrow. I really don’t have enough. Goes to show you how stingy I am. I bought them before Lehman was on anybody’s radar and I was still to cheap to gorge. Now, all of the alarms have sounded and I’ll have to pay up to participate or go in short. There is too much attention focused on Lehman right now.) 
AMBAC and MBIA

Lehman, Bear Stearns, AMBAC and MBIA all share one common trait, and that was they carried assets on their balance sheet whose value was directly related to another party paying them (or their paying another party). This compounds risk exposures when compared to many other "asset" classes. For instance, gold held on a balance sheet as a physical commodity, only exposes the holder to the market price of gold. A gold swap exposes the holder to the market price of gold, the counterparty (default risk) of the other side of the swap reneging on its obligation, AND the counterparty risk of the bank that stands in between you two of going belly up and not delivering the contracted value. That's a lot of compounded risk as compared to just holding the physical.

Despite the added risk of entering into a financial contract for an asset versus purchasing an asset, Wall Street is pushing for just that... They're selling swap trades in lieu of equity purchases to minimize their balance sheet hit in terms of newly written reserve requirements, as per regulatory authority mandates. Reference  the Wall Street Journal: Banks Pitch Swaps as Alternative to Buying Stock. Now, with that in mind, let's take a time-lapsed look at Morgan Stanley's balance sheet.

As you can see, nearly $400 billion (or more than half) of the assets on Morgan Stanley's balance sheet derive their value from their counterparty not reneging. To be particular, going down the labels of Morgan's balance sheet:

  1. Receivables from customers - Ask FXCM how those customer IOUs work out when the market disconnects. They took a $225 million loss on clients who refused to honor the banks recievables. Leucadia National Corp. had to bail them out with a $300 million loan (plus associated rights, written in blood). 
  2. Other loans - Well, loans (particularly loans that need to be called "Other") don't have static values. Speaking of loans and fluctuating values, that Lecuadia bailout loan package referenced above just got written down by more than $100 million.
  3. Securities recieved as collateral - if these securities drop in price, the contracts Morgan attempted to collateralize drop in value since the associated liabilties won't follow suit.
  4. Securities borrowed - Old fashioned margin, and there's a healthy dose of it here.
  5. Securities purchased under agreements to resell - aka repos, repurchase agreements or sale and repurchase agreement - the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price is usually greater than the original sale price, the difference effectively representing imputed interest, which is also known as the repo rate. The party that originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest. Of course, the counterparty risk lies in the other side honoring their side of the deal in buying back the securities.

All of the asset categories in the list above are highly sensitive not only to the underlying market prices, but to the willingness and capability of Morgan Stanley's counterparties to honor their side of the deal. When the other sides failed to honor for whatever reason (Lehman, Bear, GGP, MBIA, Ambac, etc.) the assets dropped in value even faster than the underlying's market price fell. Whenever this happens, correlations cause other bank's similar and/or hedged assets to drop in tandem, and then it's a party!

Let's revisit how this worked out for Bear Stearns...

Bear Stearns portfolio exposed towards Ambac is $2.2 billion

Bear Stearns portfolio insured by Ambac Ratings
Issuer Net Par Exposure ($ mn) A AAA BIG Grand Total
The Bear Stearns Companies Inc. $88   $88   $88
  $104   $104   $104
  $117   $117   $117
  $125   $125   $125
  $136 $136     $136
  $140     $140 $140
  $144     $144 $144
  $151     $151 $151
  $171   $171   $171
  $202     $202 $202
  $245 $245     $245
  $261 $261     $261
  $337 $337     $337
Total $2,220 $978 $605 $638 $2,220

Because Bear Stearns underlyings and counterparties defaulted, AMBAC was on the hook. Since AMBAC was overleveraged and suffered high correlations in opposing deals, they defaulted (big time) and... It's a party!

This is how we solved this problem over at Veritaseum. Veritaseum contracts cannot be broken or breached, thus counterparty/default/credit risk are essentially non-existent. We accomplish this by fully escrowing the entire "smart" contract through the blockchain (an immutable, and to date unhackable, consensus driven database in the cloud) and giving each party access to unlimited digital leverage to appease the "cowboy" in everyone without enabling them to take unfunded risks or potentially not deliver to the other side - regardless of how the contract and its underlying perform. Everybody always gets paid, according to the contract terms, all the time. It's a shame this can be called a new invention, but it is and we are patent pending.

Those who wish to find out more about the startup can view our public slide deck and/or contact me via email.