I've been trying really hard to understand exactly how all the banks and sovereign debt issues coming not only from Greece, but potentially from all
the other Mediterranean troubled countries are linked, and I think I finally get it. I couldn't understand why Germany and other countries would
continue to be involved in this mess, but just as the US was drawn into TARP because of our bank exposure, my understanding is the same thing is
For all the threats talked about here, I really don't think the derivative market and credit default swaps are given nearly enough attention. I'm not
an economist or financier, but my understanding is the derivative market is where you are essentially betting on whether a given economic factor or
item will go up or down. To insure bets from this market, credit default swaps are the insurance on the bets, saying the issuer will provide money if
the venture fails.
But, the nasty thing about credit default swaps that seems to be the key factor behind the 2008 US crisis, and the impending 2011 Euro crisis (which
will go global quickly), is that you don't have to be a stakeholder to make the bet that something will fail. The movie "Inside Job" did an excellent
job of describing what happened in the US where Goldman Sachs, amongst others sold bad mortgages (bundled as CDOs - collateralized debt obligations)
making money on the front end, and then bet they would default making money on the back end, largely off AIG. Of course, AIG couldn't cover the bets
because the smart money knew the failure was coming, and so it crashed and was saved only by the intervention of the central bank, the Fed, who
through a combination of taking taxpayer funds and inflating the currency, covered Sachs' and others margins.
Make that simpler. A company sold bad products, bet on them to fail, and then was paid by the government when it failed at expense to the people they
fleeced. Outrageous. But the system hasn't changed in any meaningful way, so the betting continues through today.
Now, we face Greece which presents the same basic problem. I've read article after article trying to figure out all the players, but the short
version is the European banks are scared to death of the inevitable Greek default because of all the bets on these credit default swaps. The theory
in allowing them seems to have been while some would bet things would work out, others would bet they would not, and the rate of payment on them
reflected the relative risk. But what happens when everyone's bets fail, as they probably will (given that one year bonds in Greece are now trading
at 150%, a sure sign of their insolvency) and the triggers kick in that force payment of those swaps. The banks or institutions holding them will be
unable to pay.
What makes this market even more deadly is just how far institutions have been able to leverage themselves to play. With notional investment
sometimes thirty times greater or more than actual collateral being held, it wouldn't take much to tip the first domino.
Put more simply, it's as if you or I made thirty different bets with the same dollar, saying "Well, since they're a little better than fifty/fifty
anyway, it'll all work out in the end." Banks make a ton of money when it does, creating capital basically out of thin air for their investments and
balance sheets, but what would get one of us beat up has a deadly side effect for them. What if they lose? Then, they don't just lose their shirts,
but they end up owing as much as thirty times the amount they possess!
So the real question becomes who holds these Greek credit default swaps, and how bad is the exposure? Because if it is more than the banks holding it
can pay, who from my research appear to be French and German (though there are many others linked), those banks may well be unable to meet their
obligations when Greece falls. And then, the panic sets in, and as the banks draw on other banks and other bets come into play, the same chain that
made everyone money will lose everyone money.
Here's a scary thought for you. The global annual gross domestic product is in the neighborhood of $65 trillion dollars. The global derivative
market is, depending on who you read, at least ten times larger than that. Totally unregulated, but intertwined between every bank not just in Europe
and the US, but the world.
So when the first domino is pushed, and Greece falls, the problem isn't Greece being broke or wasteful of money (though they certainly are) or
Eurocrats trying to save their currency (though they would like that too), but it's trying to prevent the fuse from being lit on what I believe to be
an unstoppable chain reaction that could potentially decimate the banking system.
Assuming there is enough money ponied up to cover the Greek default, and all the bets made against it (which to my mind is the craziest thing...how
anyone can essentially get paid insurance for something they don't own!) are paid off, billions of dollars of wealth will have been lost causing a
crippling recession, and that's the happy scenario. The unhappy scenario is a general default that begins in Greece, goes to Italy, Spain, and
Portugal, and then takes down the French and the German banks as well. At that point, the UK and US investments get hit even harder, and so on.
If my explanation hasn't been the best in this area, I apologize in advance and say I've been struggling for weeks now to really understand this. I
may not have the technical precision of others, but I do believe the basic scenario is I'm portraying is accurate, and should be much more frightening
to most people than any foreign policy threat.
I am not a fan of central banks at all, but just think what would be the consequences of a global financial collapse where the different private banks
became insolvent all at once?
For the United States is I've read 95% of these CDS's are held by just four banks: Bank of America, JP Morgan Chase, Goldman Sachs, and Citigroup.
If this goes down in the bad scenario, they will be pushed to insolvency, and you have to ask yourself what will the Fed do?
edit on 14-10-2011
by cassandranova because: clarity, punctuation