The North American media talk about Greek debt as a European problem. The exposed banks are European, not American or Canadian. In his 10 June newsletter, John Mauldin says that this may not be so. Yes, European banks bought the Greek debt, but then they bought default swaps from the "too big to fail" American banks to insure their exposure. This means that a Greek default would affect American banks much more than European banks. Another Lehman type failure is not out of the question if Greece defaults.
This would be double dip big time!
Here is an excerpt from Mauldin's newsletter:
"Time to Get Outraged by the Banks
Long-time readers know I continuously pound the table that credit default swaps need to be put on an exchange. The Frank-Dodd bill failed in so many ways to deal with the last crisis and prevent the next one, it is hard to start a list. But an analysis by economist Kash Mansori, at http://streetlightblog.blogspot.com/2011/06/betting-on-pigs.html
, tears apart the mind-numbing 146-page report from the Bank of International Settlements, which is just one long set of tables and data. I spent an hour with it and almost went blind. (For data masochists, it is at http://bis.org/publ/qtrpdf/r_qa1106.pdf
Kash had to do a lot of work to come up with his tables, which show how much exposure Europe and the US have to Greece, Ireland, and Portugal. (He very politely answered some questions when I emailed him.) There is a lot of useful information buried in the data, showing us who is exposed to the risk of sovereign defaults in Europe. I have openly speculated that US banks were selling CDS to Europe but had no idea how much. Now we do.
From Kash’s blog:
“Observation #1. Default Insurance Matters.
“First, the BIS data very helpfully breaks exposures into two pieces: direct exposures, which basically means creditors who own bonds issued by one of the PIGs; and indirect exposures, which for the most part means agents who sold default insurance to creditors, primarily through credit default swaps. As summarized in the following table, it seems that approximately 30% of total potential exposures to debt from the PIGs are covered by default insurance (see the figures in red). Put another way, if one of the PIGs defaults, creditors who actually hold bonds from that country will absorb about 70% of the losses, while agents (primarily banks and insurance companies) that sold insurance against the possibility of default will have to cover the remaining 30%. That's not a trivial amount. (All figures below are in billions of USD, as of the end of 2010.)
“Observation #2. Direct Exposure in Europe, Indirect in the US.
“The table above also hints at striking differences between how European and US creditors would be hit in the case of default by one of the PIGs. If Greece were to default, for example, approximately 94% of the direct losses would fall on European creditors, and only 5% would fall on US creditors. However, US banks and insurance companies would have to make about 56% of the default insurance payouts triggered by such an event, while European agents would make only 43% of those payouts.
“The next table illustrates this difference even more starkly. In the case of Greece and Portugal, the vast majority of the losses that would be borne by creditors in Europe would be direct losses. In fact, French and German creditors would almost certainly be substantial net recipients of default insurance payments. (That's less clear in the case of Ireland.) Meanwhile, US financial institutions would have to make substantial net default insurance payments, which would account for between 80% and 90% of all losses borne by the US in the case of default (see the figures in red below).
“Observation #3. Similar Overall Exposures in Europe and the US.
“Finally, it's worth noting that once you account for the substantial payouts that US agents will have to make to European creditors in the case of a default by one of the PIGs, financial institutions in the US have roughly as much to lose from default as those in France and Germany. (See the figures in blue in the table above.) The apparent eagerness of US banks and insurance companies to sell default insurance to European creditors means that they will now have to substantially share in the pain inflicted by a PIG default.
“This has some important implications. First, US and European financial institutions are likely to have very different incentives as negotiations regarding debt restructuring and reprofiling proceed. US banks and insurance companies are surely delighted with the " soft restructuring" that is currently being discussed. Such a partial default would probably not trigger default insurance payments, and so the pain would be borne almost exclusively by European institutions. On the other hand, some time soon it seems likely that European creditors will begin to prefer a "hard restructuring" that would require default insurance payouts from the US institutions that sold such insurance. Given how strikingly one-sided the net default insurance payments will be (from the US to Europe), it's easy to imagine how that could shape future negotiations over debt relief for the PIGs.
“Second, there's an interesting puzzle here. Why have European and American financial institutions behaved so differently when it comes to the PIGs? Specifically, why have American firms been so willing to sell default insurance to the Europeans, though they have not bought much PIG debt? And conversely, why have the Europeans systematically been so eager to buy insurance for their PIG debt, even at the very high price such insurance now commands? In essence, European firms have been betting that a PIG default will happen sooner rather than later, while US firms have been betting that default would happen later or not at all.”
If I read those tables correctly, that means US banks have sold some $120 billion of credit default swaps to European banks. Let’s think about that for a minute.
When, not if, Greece defaults, US banks are going to have to dip into capital to pay those commitments. Capital that should be available for loans to businesses but will have to be paid to European banks instead. Will it be a 100% Greek default, or only 50%? If it is a default, do you have to pay all or just the defaulted portion, and when?
Why, oh why, are banks putting American taxpayers at risk, as these too-big-to-fail banks certainly are? And make no mistake, if several major banks were to collapse, our government would need to step in. The largest banks are too big for the FDIC to handle. Now, shareholders would be wiped out this time and bond holders would face haircuts. No question. But why are investment banks allowed to mix the risk with their commercial banks?
We Need a Mulligan
I occasionally golf, more in past years than today. I am a very bad golfer. I would often negotiate in friendly games a few extra “mulligans” before we started. (A mulligan is where you get to replay the ball without taking a penalty stroke.) I was actually doing my playing partners a favor by moving the game along rather than trying to find lost balls in tall grass.
I and so many other people were all for repealing Glass-Steagall back in 1998. Sometimes we just need to admit that we make mistakes, and this was a big one. We need a national mulligan, a major do-over! We should reinstate Glass-Steagall and separate investment banking from commercial banking. Yes, I know that hurts profits and maybe makes banks less competitive, but I really don’t care. When our tax dollars are risked it is just wrong.
Further, I will bet you that bank chiefs will say they have hedged their risk on European debt. OK, I would like to know, with which counterparty? AIG? Is there another AIG looming out there, selling risk insurance? Who is paying attention?
A Congressional Investigation Is Needed
Frankly, all this needs to come out in the open. Who sold this stuff to whom and for how much, and is the risk hedged, and if so to whom? Why did someone think that betting $34 billion on the ability of Greece to pay its debts was a good idea? And are the Irish CDS sold for government debt or are they bank debt? Note that we have over $100 billion in exposure to Irish debt. Long-time readers know that I think the Irish will at some point tell the ECB to stuff it on the bank debts they assumed as taxpayers. Does this put at risk all Irish debt? It’s all in those contracts.
Maybe I am overreacting (it has happened in my life), but I simply find it outrageous that banks can risk so much with so little to lose if things go bad. Just as in the subprime debacle, they make their bonuses and salaries until the end, and the public picks up the risk. Dodd-Frank was a joke. It did not solve the real problems, and has so many unintended consequences. It should be torn up and we should start over. But first we reinstate Glass-Steagall. At a very minimum, we require that banks that want to sell credit default swaps separate that division from the rest of the bank and capitalize it separately. Investors who buy from them must know that the full capital of the bank does not stand behind the CDS. I don’t care if that cuts into profits. I just don’t want the private risk and profits to become public losses."
Sorry about the crappy formatting and the fact that the tables didn't copy. I hope it still makes sense.