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Risky Business

The headlines have been screaming it for a week – “Markets soft due to ongoing Greek Crisis,” or something similar.  But like The Onion, these headlines often have all the punchline in them and the article doesn’t give much more.  Why is the Greek crisis important for US stocks and our economy?  Why should we care?

The answer is  complicated and hard to explain in an article of less than a few thousand words.  The short version of it is very scary – because a Greek default could bring down many financial institutions across the developed world.  News outlets have been shying away from this and done, on balance, a lousy job portraying the real problem with Greece.

Not that something awful is about to happen – but the odds of cataclysm are high enough that they have become scary.  That means we have to understand that worst case scenario to understand why even a small threat of it multiplies out to a huge risk.

As many of you know, the Greek Crisis has been running in slow-motion for a long time.  The European Central Bank (ECB) has been more or less kicking the can down the road to forestall a pending default on debt to give them the time necessary to formulate a plan (or, perhaps, just stall because it is human nature – pick one).

The situation requires caution because if Greece is allowed to default on their debt – which may be the best thing for Greece in the long run – other nations with bigger debts will certainly ask for the same treatment.  The total tab will be very large and threaten the solvency of many banks across Europe.   The Euro itself could break up if it no longer is in the best interests of the member nations to be tied to other nations that could drag them down.

This may be simple enough to understand, but it still does not explain why the US markets are so jittery.  That takes a few revelations deep in the Credit Default Swap (CDS)  territory, a place that is concealed from public scrutiny by design.  It turns out that European banks wisely bought insurance against the possible default of their Greek debt.  Such a strange insurance comes only in the form of a CDS, and in this case they were issued primarily by our old friends Goldman Sachs.  Without getting into the details, the net insurance of the Greek debt is held primarily in the US because that’s where the dark side of international markets does things like this.

If Greece fails, our financial institutions are holding about half of the problem.  And if they go, so goes Portugal, Ireland, and maybe Spain and Italy.  The total potential default is about $500B, which is to say that the total liability to US institutions could run about 1/3 what we had to do in TARP back in 2008.  Except, of course, that we’re a lot weaker than we were at that time and we’ve picked up a lot more debt.  This is all before we have to account for any secondary effects that could include more CDSs against various European banks that might fail because of the initial shock.

Will this happen?  We do not know for sure yet just how it will go down.  The risk of a major cataclysm, however, has risen to an unacceptable level for many investors who would rather sit on their cash and not take any risk in the markets at all.  And so we wait.

Will the nation that gave us Western Civilization bring it down?  It’s still hard to say.  But the fact that we are even being forced to contemplate things like this is scary.  Hopefully, it’s scary enough to force some serious reckoning and plans for action.  It would be a shame to waste a crisis like this.

22 thoughts on “Risky Business

  1. I don’t have a very deep understanding of how this global financial system works. (I suspect it is so inherently complicated that it may be unknowable in a practical sense and priority should be given to simplification by eliminating classes of instruments. plus overly-large players like Goldman who are playing by rules the make up on the fly.)

    But the people of Greece see themselves told by fat-cat international bankers to take huge hits in their personal prosperity to pay for the mistakes of the supposed experts who in fact are nothing but shady snake-oil peddlers. That we do know. Why shouldn’t t they “just say NO?”

    Latin Americans have long experience of this. Even incredibly prosperous places like Argentina can be and are brought down by sufficient bad judgement and manipulation.
    (For that matter, look at Minnesota….)

    I think those people talking about “relocalization” and “self-reliance need to be part of the thought mix.

  2. Alan: That’s why I did allow that default might be the best thing for Greece – even though it’s a horrible thing for the EU. I think the situation has clearly gone past “Too big to fail” and into “Too big to understand”. You are far from alone in not understanding what is going on – I don’t think anyone, including the people who have placed very big bets (usually with Other People’s Money, the real OPM of the financial world).

  3. I’d like to know if anything good ever came from those CDS’s and why we still allow them at all. You talked before about improving the transparency but if they don’t have any real function other than to hide risk then we should just get rid of them. All I can see is another way that all these banks and trading companies take on way more risk than they should and then demand that the taxpayer bail them out.

  4. It would be interesting to look into the situations of countries that have defied, or stayed out of, the IMF system. Cuba? What others? How have they done? When something becomes pervasive enough we take it as a given and don’t think about alternatives.

    Greece, clearly has some leverage, having the ability, perhaps, to take down something bigger. This seems different from the situations of small island states nobody really cares much about or needs–except of course for the people who live there.

    Seems to me that better-governed countries must be doing some serious contingency planning for how to cope if the system does come down Ie, the dollar collapses due to US misgovernment, climate change produces chaos in multiple places, etc. (I’m not tying to label myself as an apocalypse-predictor here, just asking about contingency planning.) Has anybody seriously looked into this?

  5. Jim: I’m going to have to take a bit of a pass on this one because I’m not sure that there is anything that a CDS can do that can’t be done another way (such as more conventional insurance). If their main purpose is to hide transactions then requiring disclosure will simply make them go away and that will be that. if there is a purpose – well, with transparency I’d learn a lot more about it and I’ll let you know! 🙂 I’m not entirely against market innovation, but I do think that on balance banking should be pretty boring.

    Alan: That is an excellent question and I agree that the mark of a better governed nation is that they have contingency plans. There’s a point where an event that’s no more likely than one in a million has a potential loss of over, say, a trillion dollars – meaning that you want to think of it on balance as a roughly million dollar liability. There are a LOT of those out there right now and a plan to deal with all of this stuff is indeed necessary. But it’s a big job when you have a big nation! This is what I meant when I wrote about a Fault Tolerant society a while back:

  6. I read a good explanation along these lines a few weeks ago, but it was much longer than this. The CDS’s are pretty hard to explain easily and I can’t say that I understand it that well either but I wonder like Jim whether they are worth having at all. It seems that every single time they are used it is to somehow make a risky investment look better.

    And it is much more than Greece but they are the first ones that have to be dealt with. Ireland is already in deep trouble too.

  7. I don’t understand any of this and I only hear about things like Greece on the radio. I have to say that no one even tries to explain what is going on so I appreciate your effort. I have to read this twice before I think I get it but at least you got it out there.

    What I still don’t get is why people buy this debt from nations like Greece in the first place. I wouldn’t touch it for anything! DIdn’t everyone know this was a possibility?

  8. Dale, you have a good question here. Why buy debt that looks bad at the start? I think there are many answers. The first is that Greece should be rated to pay a higher interest rate in part because of that. The second is that these are put into bundles with better assets from other nations in a pan-European collection that should even out. Plus, with the Credit Default Swap it is mostly insured. So the banks that buy them only bear part of the risk of default.

    Despite all of that it’s clear that a lot of banks fell down in one or more of these key areas, given the potential turmoil that accompanies this event. The system is clearly “too big to understand”. I find that very, very scary!

  9. Erik, I could read and reread ’til the end of time and still not fully understand beyond the point of “Oh my God, this is some serious sh…er..stuff!” And makes all that much more nervous about the gamesmanship at both the federal and state levels.

  10. Jack, that is the real problem we are dealing with. Not only should banking be boring, fed/state/municipal bonds should be really boring, IMHO. Whenever someone has gotten creative with them (like Orange County, California) it’s been a disaster. In these pending cases we’re not even getting creative, we’re just being stubborn. >shudder!<

    It's worth noting that the use of CDSs to make sovereign debt (national bonds) more palatable appears to be an innovation for these Greek bonds that are now about to default. Thank you so very much, Goldman Sachs! Back to Dale's early question – why does anyone buy this crap? I'm starting to seriously wonder – when they get creative and/or bring in Goldman Sachs, they might as well put up a big neon sign, Do Not Buy This!.

  11. The huge amount of leverage combined with the lack of required backup capital make CDS hugely attractive…. and if something goes wrong, the lack of capitalization, pretty much means its always some other guys money at risk,. Being there was zero will to apply much if any regulation to that market, we are in the same position we were in 2008, albeit significantly less able to weather another CDS storm, both economically as well as physically.

    My guess is the citizenry of Europe is eventually going to be fed up enough, that no amount of accounting or legal gamesmanship will prevent a CDS event from occurring… and then the dominoes will fall. I think its more so a matter of when, than a matter of if.

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  13. Ron, I think you may well be right. The way the sovereign debt crises are put off by the ECB and partners, rather than solved, says that there is no political will to avoid a disaster. Dodd-Frank has simply not put up the wall necessary to prevent a collapse from going epidemic and the whole system is still terrible vulnerable, as it has been since the repeal of Glass-Steagall. This is all on top of the debt ceiling brinksmanship and that lack of leadership.

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