Greek Default: The Real Danger Lies With Derivatives Not Just Total Debt

Greece’s total debt of €340 billion (£303 billion) is well documented, as is the fact that the nation’s bailout is really a bailout of the European banks that are holding the debt. What’s not well known is that a default could trigger a 2008-style financial meltdown.

Investors have been purchasing derivatives to protect against the risk that countries might default on their debt. Derivatives are financial instruments used in the City and on Wall Street to reduce risk – a process known as hedging. In recent years however, they have become ever more prevalent and complex, which has created new kinds of risk that very few understand. A type of derivative called Mortgage-Backed Securities (MBS) played a major role in the meltdown of the world’s financial system in 2008. MBS’s are a type of asset-backed security that is secured by a mortgage or collection of mortgages.

Derivatives were once described by Warren Buffet as “financial weapons of mass destruction”, the global derivatives market is valued at around $800 trillion – more than 13 times world GDP.

The crisis in the eurozone involves another type of derivative product known as Credit Default Swaps (CDS). CDS’s are purchased by lenders from insurance companies and are designed to protect the lender in case of loan default – in which case the loan can be swapped for cash. According to Markit, a financial data firm based in London, as of last week, the price to insure against default on €10 million of Greek debt was €1.9 million per year, up from €775,000 a year ago.

Because CDS’s are traded in the Over the Counter (OTC) markets, and not an a regulated exchange, derivatives traders and analysts simply don’t know how much money is tied up in CDS contracts that will have to pay out if Greece defaults. Nor do they know what sort of threat they pose to markets in Europe and the United States.

Estimates range from €3.5 billion to €55.4 billion but the bigger danger is of contagion should other PIG countries follow Greece. Exposure to the five most financially troubled EU countries of Portugal, Italy, Ireland, Greece and Spain is estimated to be anywhere from $434 billion to $1,410 billion.

When asked about derivatives tied to Europe at a recent press conference, Fed chairman Ben Bernanke said that “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.”

A domino of PIG defaults would likely cause a rerun of the 2008 financial panic – though this time, instead of fleeing private sector debt, investors would be fleeing sovereign debt. I expect to see the widespread liquidation of all risk assets as investors greed turns to fear and many receive margin calls. In such a scenario, traditional safe havens such as US Treasury bonds might not seem quite so appealing, especially to those trying to avoid counterparty risk. The real winner in this crisis is therefore likely to be gold and after an initial selloff I expect the yellow metal to make new highs, possibly even breaking through $2,000 per ounce.

 

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