Europe’s ticking time bomb: Credit default swaps

January 4, 2012, 3:00 PM UTC

In the midst of the eurozone meltdown, a new crisis has gone unnoticed: a shaky derivatives market.

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FORTUNE — Warren Buffett once famously described credit default swaps as “financial weapons of mass destruction.” Now these complex insurance policies are once again posing a menace to America’s too-big-to-fail banks. The last time around, CDS on U.S. subprime mortgage bonds nearly brought down insurer AIG (AIG), requiring an $85 billion bailout from the U.S. Treasury. This time, the problem is European sovereign debt.

America’s banks have rightly pointed out that they are only minimally exposed to European government debt. But they have been buying and selling default protection on those bonds, doing deals mainly with investors in the eurozone. Exactly how much is not known, because CDS are held off-balance-sheet.

Some recently released European data, however, make a ballpark estimate possible. Exposure by six major American banks to CDS on Italian debt alone, for example, may be as high as $200 billion. Overall, U.S. banks may hold two-thirds of the total euro-debt CDS outstanding.

Presumably, most big banks have learned the painful lessons of 2008 and no longer take either a long or short derivatives position but hedge their exposure, making their net risk close to zero. But the real concern is: How solid are the trading partners of the U.S. banks?

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It turns out some of the largest sellers of protection are banks in Europe. French bank BNP Paribas has sold $4 billion in protection on French government debt, 12% of the global total. Similarly, Italy’s Banca Monte dei Paschi di Siena has sold $3 billion worth of protection on Italian government debt. If Italy, say, defaults on its debt, these banks might not be able to pay their American trading partners. “It’s the ultimate moral-hazard trade,” says Peter Tchir, CEO of hedge fund TF Market Advisors. “If a country defaults on its debts, these European banks domiciled in the same country will also default on their debts and won’t pay out, so why not write the protection now and make lots of money?”

No wonder hedge funds holding big positions in CDS based on European debt have started bolting for the exits. Greenlight Capital Re, an insurance company run by hedge fund legend David Einhorn, sold half its $600 million of CDS on sovereign debt in the third quarter, according to SEC filings. Gary Swiman, who heads the asset manager division at consulting firm ICS Risk Advisers, says several other hedge funds and financial institutions that he works for have followed suit. They have been spooked by the debt deal reached between Greece and its international bankers, which requires Greece’s creditors to take a 50% loss on their Greek bonds. Because the deal was labeled “voluntary,” the banks don’t have to pay up on their insurance policies. “Saying they are not going to pay has essentially ruined CDS as a form of insurance and hurts an investor’s ability to hedge,” says Bob Gelfond, CEO of the hedge fund MQS Asset Management.

Yet the day may come when Italy, Portugal, or Spain will be forced into a real default that triggers CDS. What then happens to all those pieces of paper American banks have bought from their friends in Europe?

This article is from the January 16, 2012 issue of Fortune.

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