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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