As the European financial crisis worsened during the first half of 2011, U.S. banks increased sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish, and Italian debt. Guarantees provided by U.S. lenders on government, bank, and corporate debt in those countries rose by $80.7 billion, to $518 billion, according to the Bank for International Settlements.
BIS doesn’t report which firms sold how much or to whom. Almost all of those guarantees are credit-default swaps, according to two people familiar with the numbers who asked not to be identified because they weren’t authorized to speak. Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America, and Citigroup — write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. A credit-default swap is a contract that requires one party to pay another for the face value of a bond if the issuer defaults.
The chance that banks will have to make good on the insurance grew after Greek Prime Minister George Papandreou said on Oct. 31 that he would ask the Greek people to approve the latest debt deal in a referendum, putting the agreement at risk. On Oct. 27, European leaders had persuaded bondholders to accept a 50 percent loss on their holdings of Greek debt in an agreement reached in Brussels with the Institute of International Finance, an industry association representing banks. The deal calls for a voluntary exchange of debt. Another trade group, the International Swaps & Derivatives Assn., whose top officers and directors are bank executives, decides whether a debt restructuring triggers CDS payments. ISDA said on Oct. 27 that the agreement would most likely not be considered a default since it is not binding on all bondholders.
Papandreou’s call for a referendum set off a rebellion by Greek lawmakers, including some in his own party, threatening to bring down the government. “This week’s new Greek surprises raised uncertainty,” says David Kotok, chief investment officer at Cumberland Advisors. “Markets don’t like uncertainty.”
The five U.S. banks had net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain, and Italy, according to disclosures the companies made at the end of the third quarter. In earnings reports and conference calls, the banks say their net positions are relatively small because they purchase swaps to offset ones they’re selling. In theory, if a bank owns $50 billion of Greek bonds and has sold $50 billion of credit protection on that debt to clients while buying $90 billion of swaps from others, its net exposure would be $10 billion.
Yet that math doesn’t tell the whole story. With banks on both sides of the Atlantic relying on derivatives to hedge their risks, potential losses in the event of a default aren’t being reduced, says Frederick Cannon, director of research at New York investment bank Keefe, Bruyette & Woods. “Risk isn’t going to evaporate through these trades,” Cannon says. “The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who’s ultimately going to pay for the losses?”
American banks are probably betting that the European Union will rescue its lenders, says Daniel Alpert, managing partner at Westwood Capital, a New York investment bank. “There’s a firewall for the U.S. banks when it comes to this CDS risk,” Alpert says. “That’s the EU banks being bailed out by their governments.”
JPMorgan Chief Executive Officer Jamie Dimon said last month that the bank hedges its exposure to European sovereign debt through contracts with lenders in other countries, including Germany and France. The counterparties are diversified, and JPMorgan takes sufficient collateral to protect itself against losses, Dimon said during a third-quarter earnings call. Ruth Porat, Morgan Stanley’s chief financial officer, said during a call with investors after the company’s earnings report last month that the data on European guarantees compiled by regulators didn’t take into account short positions, offsetting trades, or collateral collected from trading partners.
That’s how some Wall Street banks tried to protect themselves from subprime mortgages before the 2008 crisis. Goldman Sachs and other lenders had purchased swaps from American International Group, so when they reported subprime exposure they could reduce the amount by the CDS holdings on their books.
When prices of mortgage securities started falling in 2008, AIG was required to post more collateral to its CDS counterparties. It ran out of cash, and the U.S. government took over the company. If AIG had collapsed, what the banks saw as a hedge of their mortgage portfolios would have disappeared, leading to billions in losses. “We could have an AIG moment in Europe,” says Peter Tchir, founder of TF Market Advisors, a New York research firm that focuses on European credit markets. “A Greece default causing runs on other periphery debt, triggering collateral requirements from the sellers of CDS, and one or more cannot meet the margin calls. There might be AIGs hiding out there.”