19 November 2007


LEAP/E2020 now estimates that at least one large US financial institution (bank, insurance, investment fund) will file for bankruptcy before February 2008, sparking off bankruptcies among a series of other financial institutions and banks in Europe (in the UK especially), in Asia and in various emerging countries. According to an expression by Blackstone president Tony James's (1), a financial « black hole » was formed after the US subprime crisis.

The triggering factors for a major financial institution to go bankrupt are now so powerful and warning clues so numerous that, according to our researchers, the probability that it happens within three month now reaches 100%. Probabilities are as high that the US authorities will try to introduce a reimbursement protection-net in order to avoid panic from spreading throughout the entire US financial system (2); but the size of the bankruptcy will immediately hit the most exposed financial institutions operating in the US and in the rest of the world. Countries whose financial operators are the most linked to US financial operators will be on the frontline: United Kingdom, Japan, China in particular (3).

There are four main triggering factors, according to our team:

1. Drastic drop in revenues for banks operating in the US
2. Slumping value of assets owned by these banks resulting from new US banking regulation (FASB regulation 157)
3. Increasing weakness of bond insurers
4. Economic recession in the US

These factors must of course be placed in the general context described by LEAP/E2020 since the beginning of 2006, i.e. a global systemic crisis, which only today is beginning to be grasped by the world's political, financial and economic leaders (4). The fact that over the past two years, the largest financial operators and central banks, the US Fed and the Bank of England in particular, were systematically late on the course of events, entails to believe that they will only become fully aware of the existence of a banking crisis once some major event has happened, once it is too late to efficiently prevent the system's contamination.

University of Michigan « Consumer Sentiment » (November 2007 included) – Source: Federal Reserve Bank of Saint Louis / LEAP/E2020
In the present public announcement of the GEAB N°19, LEAP/E2020 chose to present its anticipation of drastic drops in the revenues of banks operating in the US (Factor N°1).

Factor N° 1 - Drastic drop in revenues for banks operating in the US
As detailed in GEAB N°19, the coming into effect of the FASB 157 standard on November 15, 2007, will directly involve the financial statements of financial institutions operating in the US and expose them to the consequences of a loss in value of a large proportion of their assets, knowing that this part is increasing. Indeed the subprime crisis was nothing but a catalyst for a wider-ranging financial crisis today affecting all US financial assets (5). The CDOs altogether are now dragged into a general confidence crisis, and they represent a large part of bank assets since, in the past few years, large banks from lenders became investors and speculators, like hedge funds.

By the way, the latter represented for nearly a decade a growing source of revenue for large international banks. Everyone still has in the mind the huge fees that these hedge funds and investments funds paid to the banks in the framework of their various operations such as LBOs (Leverage Buy-Out), M&As (Merger and Acquisition) and other IPOs (Initial Public Offering). These not-so-remote-times (they ended last summer) now belong to the past.

Today, hedge funds are striving to avoid bankruptcy. Investment funds deepen their losses as they try to avoid being sucked into the “financial black hole” mentioned by Blackwater's CEO (cf Factor N°2, GEAB N°19).

Merger and Acquisition projects are at a standstill. For instance, in the technology sector (a privileged target of M&As), Wall Street saw the amount of transactions decrease from USD 99 billion in the third quarter of 2006 down to USD 52 billion in the third quarter of 2007 (i.e. a 50 percent drop), knowing that the credit crisis was only beginning in the third quarter of 2007. Yet the weakness of the US dollar provoked a frenzy of European LBOs in the US; indeed for the first time the Europeans bought as much as their North-American counterparts (6).

LBO freeze – Source Dealogic
Despite the fact that IPOs on Wall Street resisted quite well the Summer crisis, they are now postponed to unknown dates, when times are less gloomy. For instance, the number of IPOs for more than USD 1 billion fell from 8 per quarter (in the third quarter of 2006) to 2 (in this year's third quarter), knowing that this trends is strengthening as recently illustrated by RWE, this German energy supplier who decided to postpone its American Water division's public listing because of the credit crisis in the US (7); another example is provided by Rusal, the Russian aluminium giant who postponed to an unknown date its planned IPO, though it promised to count as this year's most important one and despite the fact that operating banks have already been designated (i.e. Morgan Stanley, JP. Morgan and Deutsche Bank) (8).

With regard to LBOs (these remarkable financial packages which make it possible to buy a company with the riches it potentially contains (9)), the market is practically closed. Moreover all transactions that were not frozen or cancelled end up in court, as illustrated by the emblematic case of SallieMae, the student loan company, and JC. Flowers (a very active investment fund with no website!) (10). In October, LBOs only represented 5 percent of all M&As, versus 31 percent in June 2007.

US banks' level of exposure to financial derivative risks – Source Contraryinvestor
All these tendencies point in the same direction: the loss of a significant source of revenues for banks operating in the US, that will soon combine with the consequences of the implementation of the FASB 157 standard on the one hand and with the CDO crisis on the other, meaning the loss in value of an important part of the same banks' assets.

Indeed in 2006, revenues drawn from their advisory and intermediary services in LBOs, M&As, etc… represented 27 percent of their total revenue, after experiencing the strongest progression recorded in the past seven years (seven years before, in 1999, i.e. on the even of the Internet bubble burst!). Moreover in 2006 already, these revenues had to compensate for losses induced by the first effects of the subprime crisis. In 2007, losses related to the mortgage market literally exploded compared to 2006, and everyone can see that all large financial transactions' advisory and intermediary services have now dried up (11).

No need to be visionary to conclude that these banks will experience between the end of this year and the beginning of next year a severe crisis capable of entailing losses that some of them will not be able to cope with. According to LEAP/E2020, all these clues are harbingers of a major banking crisis whose causes and consequences for investors and savers are retailed in the GEAB N°19.


(1)Tony James used this expression to describe the financial environment that led his capital investment company, one of Wall Street's wonders until a few weeks ago, to announce a USD-113 million loss (source Forbes, 11/12/2007). Blackstone's shares were listed on the stock market last year, simultaneously with a number of other mega-investment funds such as KKR or Fortress, for instance. By the way, last spring, our team warned that these Initial Public Offerings (IPOs) in fact aimed at pooling future losses rather than past profits. This is now confirmed.

(2)It is already the case with “Paulson's super-conduit” (cf. GEAB N°18).

(3)For more details on the level of exposure to US financial risks, see GEAB N°16, 17 and 18 in particular.

(4) This means that they are only beginning to understand the « systemic » nature of this crisis. Until now, they first refused to admit that there was a crisis, and then they treated it as one more episode of the usual economic and financial cycles.

(5) Source: Bloomberg, 11/13/2007

(6) Source: The451Group, 10/01/2007

(7) Source: YahooNews/Reuters, 11/14/2007

(8) Source: Financial Information Service, 09/21/2007

(9) As long as they manage to convince a sufficiently large amount of financial operators to lend them the corresponding sum.

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