The Greek Issue

If you've been following the European debt situation lately you know the whole Greece issue is a constant 'on-again-off-again' soap opera as to whether an agreement has been reached to resolve the crisis.

And after the latest 'agreement', Greece is back in the news requiring more money.

It raises the spectre of whether or not a Greek default will occur.

Some have speculated there will be a default and it will destroy the Big 5 US Banks because of their derivative exposure.

That won't happen, but you may be surprise to find out why... and how this is just the tip of the iceberg on the European debt issue .

No one is really sure what happens in the credit default swap CDS markets.

No one really knows how big this market is, who the counterparties are, and, worst of all, whether the CDS contracts will actually trigger in what many would consider a default.

I say "what many would consider a default" because you are going to see any agreement in this issue ruled 'not-a-default'.

Up to now, most of the media discussion has centered on potential contagion among the banks as most of the Greek sovereign debt is held by the European banking community (and numerous hedge funds).

But the real fear amongst those who follow the situation is that the real concern lies in the area of credit default swaps (CDS).

The swaps are insurance policies, individually written, that basically say - if Greece defaults, we’ll pay you what Greece should have paid you.

Credit default swaps have grown exponentially over the last decade. Since they are individually written, there is no clear visible record of how many CDS contracts are outstanding. Also unknown is who is involved. The two parties obviously know who the counter-party is but there is no public record that would allow a regulator or a third party to find out who was involved.

What is known is that the Big 5 US Banks have sold the vast majority of this insurance, insurance which has been a cash-cow for those banks and largely responsible for those obscene Wall Street bonuses we hear so much about.

As Greece debt came up for sale, Banks and others looked at the very high and attractive yields on those Greek bonds and salivated as they bought them up.

As for the risk involved?... well, they bought insurance to protect themselves.

Then the 2008 financial crisis hit.

As the world wide economy imploded, the house of cards of sovereign debt in Europe began to collapse.

Portugal, Ireland, Italy, Spain and Greece (the PIIGS) were at the forefront of the crisis.

And lately Greece has been getting all the attention.

As negotiators on the Greek debt problem attempted to work out a solution to Greece's debt crisis, they asked the debt holders to agree to take, first 70 cents on the dollar for the debt owned to them and now 50 cents.

It was termed a 'haircut' on their investments (cutsie way of saying you're going to lose money).

But would that 'haircut' trigger their Credit Default Swap (the insurance they bought to protect them if Greece didn't pay back the full amount of the bond)?

On the face of it, it seems pretty clear. They have CDS insurance to ensure they get all their money back, Greece can't pay, insurance will cover the difference - right?

Well... not so fast.

Five of the largest US banks control 97% of all the credit default swaps.

And the total amount of these swaps and derivatives is in the hundreds of Trillions of dollars (yes... that's Trillions with a capital 'T'). JP Morgan alone holds over $60 Trillion in these derivatives.

Jim Sinclair, a precious metals and commodities trader since 1977 who has worked as am Executive member in two major Wall Street firms on the New York Stock Exchange, has discussed this issue in depth. Since the five largest US banks control 97% of all credit default swaps, a demand of payment on those derivatives would instantly wipe out these financial institutions.

Therefore it is imperative that any 'agreement' on how to deal with these bonds (and Greece's inability to deal with not paying them) cannot be determined a 'default'.

Enter the International Swaps and Derivatives Association Inc (ISDA). This is a trade organization of participants in the market for over-the-counter derivatives. Its membership consists of derivatives dealers, service providers and end users and they are the organization who make official, binding determinations regarding the existence of "credit events" and "succession events" (such as mergers), which may trigger obligations under a credit default swap contract.

In short the ISDA are the people who determine whether a credit event is a default or not.

The only problem is that the ISDA is heavily influenced (if not largely controlled by) the very big 5 US banks who hold 97% of the credit default swaps that are in question here.

If the ISDA rules that a 'credit event' (or default) has occurred in the Greek issue, the big 5 US Banks will be insolvent and wiped out. Wiping out these banks would wipe out the US Banking system.

Therefore you can be rest assured the ISDA will NEVER allow a 'legal' default on this debt.

That's why you keep hearing about negotiations on the Greece issue where bondholder's are being forced to accept 'haircuts' on their bonds.

The contention is that if the bondholder's "accept" the offer of 50 cents on the dollar, they make the event voluntary and it will not "trigger" the CDS payout.

These requests for a 'haircut' have caused lots of folks to ask for a ruling from the ISDA (the ruling group on CDS contracts). If you "accepted" an offer with a gun to your head, was it really voluntary?

Naturally the ISDA will rule that it is and therefore the CDS contracts are not triggered.

As Jim Sinclair contends the bondholders could be forced to accept 0%, the ISDA will never rule that a default because the big 5 US Banks cannot be placed in a position to pay out this insurance.

For those who think Greece will default later next month, it's not going to happen - legally happen that is.

The bondholders may be forced to lose everything, but the Big 5 US banks won't be forced to pay out on these derivatives and CDS contracts because the ISDA will never rule this issue a default.

The real focus is on what comes next.

This is what you should be watching in Europe.

In 2008, AIG had sold Credit Default Swaps (CDS) on Credit Default Obligations (CDOs). CDOs defaulted and AIG had to pay. AIG went broke. The counterparties to the CDS were Goldman Sachs, JP Morgan et al and had to be made whole on their losses that they thought were insured by AIG.

It was a crisis which could have brought down the US banking system.

In response the US Government intervened and funneled TARP cash thru AIG to Goldman Sachs, JP Morgan et al to cover losses

IN 2012, Greece is about to default, just like the CDOs of 2008.

The ISDA (controlled by the Big 5 banks) will rule that any haircut on Greek bonds is not a default. Therefore the Big 5 Banks will never have to pay off on CDOs bought by Greek bondholders.

But the Greek bondholders, who thought they had principal insurance, are now screwed and are left holding the bag.

This is what caused MF Global to go under when the first Greek 'haircut' was not ruled a default.

Those Greek bondholders (the big Euro banks, big Euro govts, big hedge funds) will now be insolvent. They are going to require massive capital injection.

As those CDS contracts do not kick in, the next phase begins to unwind.

What good is insurance that doesn’t pay off? Does it mean all CDS insurance is useless? Who will be the next to fail because the insurance they thought was protecting them isn't going to pay out?

As you have read on this blog ad nauseum. The 2008 Financial Crisis was a financial earthquake, the repercussions of which many of us still do not understand nor appreciate.

That's why the big 8 Central Banks of the world have been involved in another round of massive money printing - to try and save Greek bondholders. And the level of money printing has only just begun.

As I have said, we are still only beginning to realize how profound and far reaching the 2008 Financial Crisis really is.

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Epic? (updated)

The big news today is rampant rumours of an impending Greek default and it has some speculating that the big day may come as soon as September 20th.

The thinking is that Greece has two big bonds with coupon payments due that day totalling 769 Million Euro. So if the IMF wanted to avoid letting another billion euro go down the drain, September 20th would be a good day to do it.

Then there is the US Federal Reserve.

The Fed has their rare 2 day FOMC meeting starting on September 20th.

Maybe the fact these two events fall on the same day is a coincidence, but what better way to be prepared for new emergency policies than to have to act on a Greek default?

Speaking of FED rumours, financial analyst David Rosenberg has been speculating that the outcome of the FOMC meeting could produce stimulus far greater than what anyone is expecting.  "If Bernanke wants to juice the stock market, then he must do something to surprise the market. 'Operation Twist' is already baked in, which means he has to do that and a lot more to generate the positive surprise he clearly desires."

All of this is clearly spooking China.

As Ambrose Evans-Pritchard notes in The Telegraph, a key rate setter for China's central bank let slip that Beijing aims to run down its portfolio of US debt as soon as safely possible.

"We would like to buy stakes in Boeing, Intel, and Apple, and maybe we should invest in these types of companies in a proactive way. Once the US Treasury market stabilizes we can liquidate more of our holdings of Treasuries," he said.

This appears to be the  first time that a top adviser to China's central bank has uttered the word "liquidate" in relation to US Treasuries. Until now the policy has been to diversify slowly by investing the fresh $200bn accumulated each quarter into other currencies and assets – chiefly AAA euro debt from Germany, France. 

And what size of a 'liquidation' are we talking about?

It is estimated that over $2.2 trillion US Dollars is held by SAFE (State Administration of Foreign Exchange), the bank's FX arm. 

Finally, the last tidbit in the rumour mill for today focuses on the infamous JP Morgan.

As we posted yesterday, a detailed class-action lawsuit has been publicly released on the silver price manipulation activities by JPM. The suit outlines exactly how JP Morgan has been conducting it's manipulation including specific names and titles of those JPM employees involved.

But the rumours focus, not on the Silver manipulation lawsuit, but on JPM's outstanding derivative position.

As faithful readers probably already know, JP Morgan is sitting on a $80 trillion plus derivatives monster.

Derivatives are securities whose value depends on the values of other basic underlying securities. Derivatives have exploded in use over the past two decades. They include such well known instruments as futures and options which are actively traded on numerous exchanges and as well numerous over-the-counter instruments such as interest rate swaps, forward contracts in foreign exchange and interest rates, and various commodity and equity derivatives.

And as noted at the end of this 2009 Business Week article, JP Morgan has the face-value equivalent of a mind-boggling $87 trillion in derivatives on its books.

Although your dutiful scribe cannot confirm it with a credible citation, the chatter is that if the price of Silver remains above $36 per ounce by mid/late October, the first of JPM's derivative bombs will denonate in their faces.

October always seems to be a volitle month in the world of global finance.

But if even only one of these stories plays itself out, October 2011 could be an epic month for the ages.

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Update

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Former U.K. Prime Minister Gordon Brown is speaking at the World Economic Forum in the Chinese port city of Dalian today and his candor is nothing short of astounding.

• "European banks are grossly under-capitalized and the debt crisis is more serious for the region than the 2008 meltdown as governments are constrained by fiscal pressures. In 2008, governments could intervene to sort out the problems of banks. In 2011, banks have problems, but so too do governments."

That, in a nutshell, says it all.

But Brown went on and noted that while the ECB is part of the short-term solution, it needs additional assistance. The European Financial Stabilization Mechanism, which is run by the European Union’s 27-nation executive arm, is “not enough.”. “Substantially more resources” are required.

• “The euro area problem is now moving to the center. The euro cannot survive in its present form, it’s going to have to be reformed dramatically. We are, I think, at an hour to midnight in the way that we look at this issue.”

A debt problem cannot be resolved with the creation of more debt, which is what authorities have been trying to do. 

• “European banks as a whole are grossly under-capitalized. We’ve now got the interplay between banks that are not properly capitalized and sovereign debt problems that have arisen partly because we’ve socialized or accepted responsibility for the banks’ liabilities.”

Do you think you will ever hear such candor from the likes of US Federal Reserve Chairman Ben Bernnake?

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Jon Stewart on Derivatives and the Greek Crisis

Last night Jon Stewart had a great take on the Greek Crisis which summarized many of the points from yesterday's post, including how America's debt situation is actually worse that Greece and how no one knows the impact of the derivatives mess.

Unfortunately I can't embed a clip from the show, however if you follow this link you can watch the segment (if you are viewing from Canada) on the Comedy Network.

If you are in the United States, go to http://www.thedailyshow.com and it's the first segment on the June 22nd, 2011 show.

There is an audio version of the segment on youtube put to assorted pictures here:

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Greece, the PIIGS and why it is so important

On a day where the main distraction is Ben Bernanke, the Federal Reserve and QE3, the real story remains Greece and the PIIGS of Europe (Portugal, Ireland, Iceland, Greece and Spain).

This issue has never really gone away.  And the average person really doesn't have a clue what all the fuss is about.

Oh sure... it's about sovereign debt, but no one really knows much beyond that.

It all has to do with derivatives, that obscure financial concept that everyone seems to have vaguely heard about but no one seems to really understand.

Derivatives are financial instruments that were created to reduce risk, and their use on Wall Street is known as hedging.

In recent years their prevalence and complexity has ballooned creating new kinds of risk.  The name "derivative'' comes from the fact that their value "derives" from underlying assets like stocks, bonds and commodities.

In the years leading up to the financial crash, banks made billions by selling complex derivative contracts directly to buyers, pocketing hefty fees but absorbing considerable risk as well.

And it is that risk that is the problem.

Although America’s housing collapse is often cited as having caused the financial crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators - sometimes even beyond the understanding of executives peddling them

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman Bros.

In the case of A.I.G., the derivative virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models.

By 2008 these derivatives nearly decimated A.I.G, one of the world’s most admired companies which had seemed to be a sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.       

When all was said and done, A.I.G. needed a $182 billion dollar federal bailout.  And it was all because of these infernal 'derivatives'.

In years past, when financial crises in Argentina and Russia left those countries unable to make good on their government debts, they simply defaulted.

But this time around, credit default swaps and other sorts of derivative contracts have become so common and so intertwined in the financial markets that there are fears among regulators and financial players that a Greek default will wreak havoc among derivatives holders.  

The looming uncertainties are whether these derivative contracts - which insure against possibilities like a Greek default - are concentrated in the hands of a few companies, and if these companies will be able to pay out billions of dollars to cover losses during a default.

If there were a single company standing behind many of these contracts, that company would become the A.I.G. of the euro crisis.

     

The central banks of both Europe and the United States will not say whether their researchers have studied holdings of derivative contracts among nonbank entities like insurance companies and hedge funds.

When Ben Bernanke, the chairman of the Federal Reserve, was asked about derivatives tied to Europe at yesterday's press conference, he said:

• “A disorderly default in one of those countries would no doubt roil financial markets globally. It would have a big impact on credit spreads, on stock prices and so on. And so in that respect I think the effects in the United States would be quite significant.”

Derivatives traders and analysts are debating just how much money is involved in these contracts and what sort of threat they pose to markets in Europe and the United States.

According to Markit, a financial data firm based in London, the gross exposure is $78.7 billion for Greece. And there are many other types of contracts, like about $44 billion in other guarantees tied to Greece, according to the Bank of International Settlements.

The gross exposure of the five most financially pressed European Union countries - Portugal, Italy, Ireland, Greece and Spain -  is about $616 billion. And the broader figure on all derivatives from those countries is unknown.       

    

This is why the Europeans have been wrestling this week with the ridiculous “voluntary” Greek bond financing solution.  They are trying to sidestep a default because they simply don' know what's out there.

And they're afraid.

Afraid of an outright default because the financial industry is still refusing to provide the disclosure needed to understand the depth and scope of the actual problem.

Said Christopher Whalen, editor of  the Institutional Risk Analyst: "They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”       

It is suggested that the depth and breadth of the contagion that might occur among swaps holders in the case of a Greek default is massive.

European leaders have said there’s no way we’re going to let Greece default even though it is abundantly clear to everyone that this is the best solution - just as it was for Argentina and Russia several years ago.

Skeptics fear their commitment is so severe because they aren't really sure what they are dealing with.

When asked what data the Federal Reserve had collected on American financial companies and their swaps tied to European debt, Barbara Hagenbaugh, a spokeswoman, referred to a speech made by Mr. Bernanke last May in which he did not mention derivatives tied to Greece.

At yesterday's press conference, Bernanke said that commonly cited data on derivatives do not take into account the offsetting positions banks have on their Greek exposures. And with those positions, he said, even if there is a Greek default, “the effects are very small.”

(This, of course, is the same Ben Bernanke who swore up and down to congress in 2006 that the subprime mortgage condition was also 'very small' and would not be an issue)

At the European Central Bank, Eszter Miltenyi, a spokeswoman, said: “This is much too sensitive I think for us to have a conversation on this.”           

It is widely believed by many insiders that the financial industry's process for unwinding credit-default swaps couldn't possibly run smoothly if Greece defaulted.

Derivatives tied to a country’s debt do not pay out over time, they pay out on one occasion: if a default occurs. That makes sovereign derivatives  similar to derivatives on corporate bonds and different in some ways from the situation at A.I.G. Under normal circumstances they can be unwound smoothly.  But not if the risk were concentrated in just a few weak institutions.

Derivatives have been called the 'financial instruments of mass destruction'.

Will the derivatives of the PIIGS blow up the financial world the same way the derivatives of Bear Stearns, Lehman Bros and A.I.G. did?

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