Back to the Brink of Disaster

The fallout from derivatives—this time tied to Greek debt—could trigger global financial contagion. How could we be dumb enough to let it happen again?

I understand why the Greek debt crisis is a big issue in Europe. The European Central Bank holds about $200 billion in Greek debt.

Regional banks in Germany have enough of the bonds stashed in their portfolios that some technically bankrupt banks could be forced to declare actual bankruptcy. The wage cuts and tax increases that have sent tens of thousands of Greeks into the streets to confront helmeted, baton-wielding riot police hang over workers in Portugal, Ireland, Belgium....

But why should the rest of the world care?

Greece is the 39th-largest economy in the world, according to the CIA World Factbook, once you correct its gross domestic product for differences in purchasing power. That puts it below Nigeria, Venezuela, and the Philippines—and just above the Ukraine.

If any of those countries were teetering on the edge of default, would world financial markets blink?

Here's why we should care: derivatives. The same toxic stuff that brought down Lehman Brothers and that was just a bailout away from taking down American International Group (AIG) and, perhaps, the global financial system, is at it again.

Mario Draghi, who will replace Jean-Claude Trichet as head of the European Central Bank, said as much at his confirmation hearing on June 14. Who knows what the effect of a Greek default would be, he said to the European Parliament.

Sure, everybody who owns Greek bonds is insured in the derivatives market using credit-default swaps against the risk of default. But "who are the owners of credit-default swaps? Who has insured others against a default of the country? We could have a chain of contagion."

In other words, according to this delightfully blunt Italian banker, three years after derivatives almost destroyed the global financial system, they again pose an unknown risk to global finances.

This, to me, is the most troubling aspect of the Greek debt crisis. We've wasted a crisis that took the financial system to the brink of disaster. We don't have any better idea today of where the risk is, because derivatives still represent a dark place on the map.

We might as well label it, "Here, there be dragons."

NEXT: Remember What Happened Last Time?

Remember What Happened Last Time?
The investor who buys a credit-default swap is looking for insurance against a default of the underlying debt instrument. The seller of the swap offers a guarantee of some payment against that default.

In the run-up to the collapse of the mortgage-backed debt market, everybody was looking for this kind of insurance. Everybody wanted the extra yield that came with these bundles of mortgages.

Even though they may have had doubts about the claim that bundling together some risky subprime mortgages produced a low-risk, AAA-rated security, buyers were willing to swallow their worries, because they could buy a credit-default swap contract that transferred the risk to some other party.

Even after paying the premium for the credit-default-swap insurance, these subprime-mortgage-backed securities paid more than similarly rated government bonds.

At their peak, credit-default swaps had a notional value of $62 trillion, according to the International Swaps and Derivatives Association.

Why "notional" value? Well, there was no way to know what these derivatives were actually worth, because there was no market for most of them.

No one knew how good such swaps were as insurance, either, because no one knew who the counterparties were to many of them, how much of the risk those counterparties had sold off to others, or how much collateral stood behind any given swap.

Outsiders didn't stand a chance at valuing these derivatives or calculating their risk—but, it turned out, neither did the players themselves.

AIG, for example, held a derivatives portfolio with a notional value of $400 billion before the crisis. In a December 2007 conference call, the company said that a write-off of all its credit-default swaps rated A or below would produce a loss of just $421 million.

Nine months later, the company was desperately looking to raise $80 billion to prevent a default on its credit-default swaps. The derivatives had tumbled so far in value that AIG needed to raise massive amounts of cash to pay off buyers of the derivative insurance it had sold, and to put up more collateral to back its swaps.

The US government finally decided to provide the cash, out of fear that an AIG default would send the value of other swaps plunging, wiping out some large portfolios and rendering worthless the derivative insurance other investors were counting on.

The derivatives market is smaller now. The notional value of the US credit-default-swaps market is about $16 trillion. The notional value of euro-denominated swaps contracts is $8 trillion. But $8 trillion, I might point out, is nearly three times the size of the German economy.

The notional value of Greek credit-default swaps was about $85 billion in April 2010. That's about twice as much as in mid-2009.

That increase shouldn't surprise you. After all, how many investors would buy Greek ten-year bonds—even with their 18% yield—if they couldn't lay off some of that default risk in the derivatives market?

Do we know who owns these Greek credit-default swaps? Not in most cases. Efforts to create public markets for derivatives trading have captured only part of the total.

Do we know the strength of these counterparties? Or how much risk they've sold to other derivatives players?

When Draghi talks about contagion, part of what he's talking about is the ability of the derivatives market to transmit risk, at blinding speed, to unidentified financial players, in volumes with the potential to turn them into a slag heap of collateral calls.

How Greek Contagion Could Spread
But that's only part of the possible contagion. Estimates put the total for all sovereign credit-default swaps at somewhere around $2 trillion to $3 trillion. A Greek default could trigger a repricing of the credit-default swaps on Irish, Portuguese, Belgian and Spanish debt that could wreck the portfolios of counterparties.

And a Greek default isn't the only risk. If Greece manages to restructure its debt in a way that doesn't trigger a default—through a "voluntary" extension of the maturities of Greek debt by some bondholders, say—that, too, might lead to a repricing of credit-default swaps.

Such a selective restructuring that doesn't trigger the insurance policy of credit-default swaps might lead some investors to conclude that the derivatives aren't worth nearly as much as they thought.

Insurance that doesn't pay off has questionable value, after all. And that, too, could lead to troubles in derivatives portfolios.

It's not like European financial institutions have a lot of cash to throw at a derivatives crisis. The European Central Bank is estimated to be on the hook for $200 billion in Greek debt that it has bought to prop up Greek government bonds.

A Greek default would put the European Central Bank, hat in hand, on the doorstep of not-terribly-sympathetic governments in Berlin and other northern European capitals—at the same time as some European banks would also be looking for capital and liquidity.

The likelihood is that a Greek default (or credit event short of a default) won't hit a financial institution big enough to turn the current Greek crisis into a European or developed-markets crisis. But no one knows for sure.

And when investors can't figure out where risk might lie, or put a reasonable estimate on its dimensions, the financial markets get very, very nervous indeed.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.