We'll I know it's been a while since my last post, I do intend on making up for lost time shortly. When a guy goes away for a week (with no phone or email), it leave quite a bit of work when you return. We'll I was poking around over at Corner of Berkshire and Fairfax today and posted this reply to a comment on Bank of America (BAC). To save money and use the shotgun approach, I am re-posting here to save time.
Just so everyone knows, and to repeat from my first post ever, I don't enjoy rehashing the latest news and current events. I strive to provide original content, full of facts and written in an enjoyable way. This post does discuss Europe which I have been trying to avoid since it's not original, but I believe contains some interesting facts and puts things into perspective. Enjoy!
Can you please provide sources for your numbers? For instance that the big 5 banks have CDS exposure of $244 trillion? I think you might be confusing CDS exposure to total notional derivatives at the big 5 banks. For instance BAC has $68.2 trillion in total notional derivatives outstanding. What is interesting is 86% of these are interest rate contracts. Specifically, looking at the CDS exposure, they have written about $2 trillion in CDS and have also purchased $2 trillion in CDS contracts. Actual net exposure is about $100 billion CDS written and $100 billion CDS purchased. At the end of the day netting CDS assets from liabilities gives an asset of $5.6 billion down from $6.6 billion and the beginning of the year.
Now the real question is who/what are the CDS contracts written on AND who/what are the CDS contracts purchased on? If you know I would like to know. When people talk about banks being black boxes this is exactly what they mean (or should mean).
Many say banks are black boxes because of the removal of mark to market (FASB 157), which is not true. Mark to market still applies unless the market is illiquid or non existent. For BAC Level 3 assets (the ones marked to fantasy) are 2.9% of total assets and 4.8% of risk weighted assets (RWA).
Ironically, these are the best among the large US banks, including WFC, JPM, C. So when pundits toot their horn saying you can't believe the balance sheet, this is the part they are talking about. This brings me to my next point.
Many people claim that JPM has a rock solid balance sheet. This includes newspapers and the nut jobs running around over at seeking alpha that either post OR comment out of ignorance. Level 3 assets are 5.0% of total assets and 9.3% of risk weighted assets at JPM. That is enough to drive a truck through. They also have the largest notional amount of derivatives outstanding and the largest amount of trading assets. If anyone says JPM has a rock solid balance sheet (including Jamie Dimon), are talking their own book or don't know the facts. The only company with a rock solid balance sheet is Wells Fargo, the only one that didn't need TARP.
Now I am long BAC. The reason why I am long is because the numbers just say they are too cheap. If they earned 1% on assets or 10% on equity that would be $22 billion profits vs a $55 billion market cap. Even if the market cap doubled to $110 billion that still would only be 5 times average earnings. The math isn't hard. But i'll be honest; the reason why BAC is a crappy company is management. How many screwups in the past year? You can't even count them on all your fingers and all of your toes.
Anyway getting back to the CDS stuff, it's not nearly as big as you think and if you have any details on who/what then that would be of value. From what BAC has broke out on Europe in Q3 they have $1.5 billion in derivatives outstanding on Italian sovereign debt (likely CDS written) and have purchased $1.2 billion in CDS protection. The net is about $300 million or not enough to worry about. They also have some exposure Portugal and Spain in the tens of millions, but they are totally covered by CDS protection purchased.
Just to put the European debt crisis in perspective, the US debt crisis was $15 trillion of bad mortgage loans against a $15 trillion dollar economy. Huge. If you add up all the sovereign debt of the PIIGS, it's $4 trillion at risk against a $15 trillion dollar economy (European union). In my opinion, Italy and Spain won't default and they contribute $2.2 trillion and $0.9 trillion respectively to that $4 trillion total. So the rough $1 trillion that's left isn't as much as the pundits make it out to be. Now if the creditors accept a 50% haircut that further brings it down to $500 billion, something still very large but not unmanageable. The real reason why Europe is a mess is because of the political structure and the inability to run a printing press to bail them out.
Disclosure - Long WFC and BAC