Why Bankers Fear Euro Default

Both European and American banks stand to lose big if a European sovereign goes bust...

THE GREEK bailout deal isn't worth the paper it's printed on, writes Dan Denning for the Daily Reckoning Australia.

A leaked memo prepared for Europe's finance ministers – BEFORE the deal passed – revealed that the austerity measures could make Greece's debt-to-GDP blow out to 160% by 2020, instead of reducing it. This proves the point we made yesterday: the bailout is not about reducing Greek's debt at all.

What's worse, finance ministers were told that Greece would eventually need another bailout anyway, even after this rescue plan. Under the "tailored downside scenario" as reported by the Financial Times, Greece would need €245 billion in bailout funds to pay its debts and recapitalize its banking sector. Before the ink was even dry on the first agreement, larger amounts for a future bailout were already being discussed.

Here are a couple of questions. Who are the private creditors being forced to take a loss on their bonds? And which financial institutions have the most to lose in the derivatives market if Greece defaults?

The first question is important because private creditors are still the ones who could bring the whole deal unstuck. It probably doesn't make sense to you that a lender would voluntarily accept a 74% loss in net present value on an investment in anything but the direst circumstances. So who are these lenders and why are they allowing themselves to be rolled?

The major creditors to Greece – the firms that stand to lose the most from a default – are represented by the Institute for International Finance (IIF). The IIF negotiated the debt swap deal, which includes the 74% write-down on behalf of its members. The important point is that those members still have to individually agree to the terms.

Who are the members? According to BusinessWeek:

"The IIF's steering committee that negotiated the swap included representatives from banks and insurers with the largest holdings of Greek government bonds, including National Bank of Greece SA, BNP Paribas, Commerzbank AG, Deutsche Bank, Intesa Sanpaolo SpA, ING Groep NV, Allianz SE and Axa."

The IIF has a larger group called the "creditors committee" made up of 32 insurers and banks. These are the main banks and financial firms facing the write-down in the value of their Greek debt. So why are they willing?

The main answer is that they've already written that value down on their books. They've used the three months since the Long Term Refinancing Operation (LTRO) began to prepare for just this moment. They could've borrowed money from the European Central Bank (ECB) to replenish their capital levels after taking the Greek loss.

In other words, they don't mind taking the loss now because they've been planning on it for three months with the ECB. And because many of the firms in the IIF are the same as the firms in the ISDA we mentioned yesterday, they are all keen to save each other's skin.

It's possible, of course, that one or two creditors to Greece simply refuse to go along with the deal as negotiated by the IIF. If you were an old-fashioned advocate for the rule of law and the rights of secured creditors, you'd object to the deal on principle. But principle and the rule of law don't matter much in the financial world right now.

Besides, under the "collective action clauses" we mentioned yesterday, the Greek government can pass a law which, according to BW, "allow it to enforce losses on bondholders refusing to take up the offer. The government would need support from the owners of 50 percent of the bonds to force the rest to accept."

Greek's four largest banks are the government's biggest creditors. If they throw their lot in with BNP Paribas, Deutsche Bank, and the other key members of the IIF, any smaller creditors wishing to object (like a hedge fund) will be forced to go along. The fix is in, in other words.

We know now that private creditors will mostly go along because they all belong to the same club. What's more, that club has set up a bank, called the European Central Bank, which is happy to provide members of the club with as much money as they need to offset their losses from Greece and still remain solvent and liquid.

This brings us to the second question, who stands to lose the most from a Greek default? Well, a default would trigger a chain reaction in the derivatives market. Insurance policies purchased against default would be activated. The insurer who sold that policy would have to pay up.

As we said yesterday, the nominal amount of Greek debt shouldn't be enough to take down the market. But in the derivatives market, it's not the nominal amount of debt that matters. This can get complicated. Let's try and keep it simple.

In the real world, you buy insurance from an insurance company. For example, you can buy insurance to cover your house from fire or flood damage. When you buy it, you buy one policy from one company and pay one premium. That's not how it works in the financial derivatives market.

In the financial world, anyone can sell insurance on anything to anyone. You can sell more than one insurance policy – a credit default swap for example – on one asset, like a Greek government bond. This is how it comes to pass that the amount of derivatives far exceeds the value of the underlying assets in the financial system.

In the interests of sanity and clarity, we won't write a lot more about what derivatives are and how they work. But you should know according to the Bank of International Settlements, the total notional value of the over-the-counter global derivatives market was $708 trillion in June of 2011, or 11.4 times the size of global GDP in 2010.

You can imagine the carnage. As assets linked to one another fall or collapse in price, the whole market unwinds. The profits of the banking system vanish. The financial system is revealed as a giant leveraged sham based on the expansion of debt.

Now the ISDA will tell you that the "notional value" of derivatives overstates the size of the market. In its year-end market analysis for 2010, the ISDA wrote that once you "net out" the market, it's only about $21 trillion in size, or 3.5% of notional value. In other words, if all the parties who owed each other money cancel out their obligations, the real size of the obligations would be much smaller.

A simple way to think about this is that if you owed Fred $10 and Fred owed you $10, the notional value of your debts is $20. In reality you really owe each other nothing because your obligations are the same. If Fred owes you $13 and you owe Fred $10, then the net value of your mutual obligations is $3.

This is a grossly simplistic version of netting out. But the ISDA says that derivatives don't really imperil the financial system because the "netting" value is a fraction of the "notional" value. We could all simply forgive each other's debts and we'd be back where we started.

If that were the case, the members of the ISDA wouldn't be worried about the credit default swaps related to Greek debt. But they are. And the members most worried are the five US banks that write 97% of all credit default swap contracts in the US.

Those banks – JP Morgan, Morgan Stanley, Goldman Sachs, Bank of America, and Citigroup – are all represented on the board of directors of the ISDA. Those banks have collected income by selling credit default insurance on European banks. Those banks stand to lose the most if Greece defaults.

It's not that complicated at all, then, is it? Banks in Europe don't want Greece to default because they own Greek debt. Banks in America don't want Greece to default because it would trigger payments on the credit default swaps they've sold. The solvency of banks on both sides of the Atlantic depends on Europe's most-indebted governments never defaulting on their bonds.

This puts the interest of the bankers and their central banks in direct opposition to the people responsible for paying off the accumulated debts of the Welfare State. The Greeks in Greece. The Spanish in Spain. The Italians in Italy. The Irish in Ireland. And the Americans in America.

To be sure, all these people got the government they deserve. And for the most part, none of them complained about the true nature of the financial system when credit expanded and drove house and stock prices up. But now that the butcher's bill for the boom has arrived, we all realize whose ox is about to get gored. Yours.

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