Could a Greek default ripple through the U.S. financial system?
It seems like a long shot. U.S. banks hold just $7.3 billion in loans to Greece and numbers disclosed by Bank of America (bac), for instance, show a Greek government default would barely dent quarterly profits, such as they are.
Yet no one can safely predict that a Greek default would be contained. For this we can thank the risk-hiding magic of derivatives, which were so instrumental in the AIG (aig) fiasco, and the hair-pulling disclosure practices of the banking industry.
You might hope the banks won’t lightly repeat the credit bust by again betting the house that financial gravity no longer applies. But times are sort of desperate for the banks, whose profits are being squeezed and their stock prices slammed. Show some bonus-obsessed traders a bet that looks like a sure thing and who knows what kind of hijinks might ensue.
“I don’t think it’s too likely you’d have a big hit to the banks over here, because they have to be leery of putting too much of the company at risk,” says Paul Miller, a financial institutions analyst at FBR Capital Markets. “But you can’t really be certain because of all you don’t know.”
We do know that the big U.S. banks are huge players in derivatives – largely in foreign exchange and currency bets, but also to a lesser extent in credit derivatives such as credit default swaps, which enable users to bet a debt issuer will fail to make payments on time.
Even if derivatives don't match the damage they wrought in the last meltdown, they still pose an enormous threat to the financial system. JPMorgan Chase (jpm), Citi (c), Goldman Sachs (gs) and Morgan Stanley (ms) together had $288 billion of derivative liabilities at year-end (see chart, right), a measure of systemic risk reflecting the payments they are due to hand over when those contracts end. They have that much and a bit more in derivative assets, reflecting payments they stand to receive when other contracts end.
We know too that lots of wagers are being made on possible defaults in Greece, Portugal and Ireland. The market is pricing in a 71% chance Greece will fail to make payments within five years, according to CMA data, and insuring against a default is accordingly pricey. A Greek default would trigger $5 billion in net payments by protection sellers to protection buyers, according to the Depository Trust & Clearing Corp. Around $11 billion more hangs in the balance depending on what happens in Portugal and Ireland.
The question is who would be making those payments. There are some signs, though they are far from conclusive, that U.S. firms could end up on the hook in a Greek default to the French and German banks that are the biggest foreign direct lenders to Greece.
Kash Mansori*, an economist who writes the StreetLight blog, says a close look at cross-border data released quarterly by the Bank for International Settlements suggests U.S. firms may have been large writers of CDS protection on Greece, Portugal and Ireland.
U.S. banks have $32 billion in contingent guarantee contracts outstanding on Greece, according to the BIS data. That number includes all sorts of arrangements, including letters of credit, so it is impossible to know for sure how much of that sum represents amounts that would be paid out on credit default swaps in the event of a Greek default or restructuring.
But Mansori reasons that since U.S. banks don’t do much lending in Greece , they probably aren’t doing a lot of other guarantees either – except, perhaps, for writing CDS on Greek debt held by others, presumably mostly to the benefit of the French and German banks. Those trades stand to have been big money makers in recent years, as spreads on Greek swaps have widened sharply as the nation's finances have collapsed.
If big U.S. financial firms are making big, unhedged bets that Greece won’t default, they could be raking in big bucks now -- while risking another black eye with the taxpayers who will no doubt end up on the hook should things go sour again.
“This could create a serious backlash for the banks if it turns out this is what’s going on,” says Mansori, who doesn’t own or bet against any U.S. bank stocks.
But is that what’s going on? It's hard to say. There is little sign in any of the banks’ filings that they are piling onto the Greek default trade. BofA, the bank that provides the most data, shows just $16 million of Greek sovereign debt on its balance sheet as of March 31 – offset by $31 million of net credit protection.
“It’s a pretty small position and we’re overprotected on it, actually,” a spokesman says.
The other banks’ filings are less detailed, but it seems a stretch to fear outsize exposure. JPMorgan Chase CEO Jamie Dimon has described his bank’s exposure to Greece as near zero, and Greek debt doesn’t even appear in the latest quarterly reports by Goldman or Citi. The firms’ dealings with Greece fall below the federal disclosure standard that obliges banks to show all foreign claims amounting to 0.75% of assets or more.
So the BIS data can arguably be read to show a good bit of CDS writing, but it’s hard to find much of it in bank regulatory filings.
“That’s a little bit of a puzzle,” admits Mansori.
And so it is with the black boxes that constitute the bulk of our taxpayer-backed financial system. They look mostly like they are on the up and up, but who can ever say for sure? The reality is we won't really know till Greece hits the wall and some big U.S. bettor takes a big hit -- or not, as the case may be.
“Welcome to my life,” says Miller.
*Initially I misspelled his last name as "Mansoor." My apologies for the error.