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Derivatives Cloud the Possible Fallout From a Greek Default

It’s the $616 billion question: Does the euro crisis have a hidden A.I.G.?

European Central Bank
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European Central Bank

No one seems to be sure, in large part because the world of derivatives is so murky. But the possibility that some company out there may have insured billions of dollars of European debt has added a new tension to the sovereign default debate.

In years past, when financial crises in Argentina and Russia left those countries unable to make good on their government debts, they simply defaulted. But this time around, swaps and other sorts of contracts have become so common and so intertwined in the financial markets that there are fears among regulators and financial players about how a Greek default would play out among derivatives holders.

The looming uncertainties are whether these contracts — which insure against possibilities like a Greek default — are concentrated in the hands of a few companies, and if these companies will be able to pay out billions of dollars to cover losses during a default.

If there were a single company standing behind many of these contracts, that company would be akin to the American International Group of the euro crisis. The American insurer needed a $182 billion federal bailout during the financial crisis because it had insured the performance of mortgage bonds through derivatives and could not pay on all of them.

Even regulators seem unsure of whether a Greek default would reveal such concentrated risk in the hands of just a few companies. Spokeswomen for the central banks of both Europe and the United States would not say whether their researchers had studied holdings of such contracts among nonbank entities like insurance companies and hedge funds.

Asked about derivatives tied to Europe at a Wednesday press conference, Ben S. Bernanke, the chairman of the Federal Reserve, said that the direct exposure is small but 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.”

Derivatives traders and analysts are debating just how much money is involved in these contracts and what sort of threat they pose to markets in Europe and the United States. On the one hand, just over $5 billion is tied up in credit-default swap contracts that will pay out if Greece defaults, according to Markit, a financial data firm based in London. That is less than 1 percent the size of Greece’s economy, but that is a conservative calculation that counts protections banks have in place offsetting their positions, and is called the net exposure.

The less conservative figure, the gross exposure, is $78.7 billion for Greece, according to Markit. And there are many other types of contracts, like about $44 billion in other guarantees tied to Greece, according to the Bank of International Settlements. The gross exposure of the five most financially pressed European Union countries — Portugal, Italy, Ireland, Greece and Spain — is about $616 billion. And the broader figure on all derivatives from those countries is unknown.

The pervasiveness of these opaque contracts has complicated negotiations for European officials, and it underscores calls for more transparency in the derivatives market.

The uncertainty, financial analysts say, has led European officials to push for a “voluntary” Greek bond financing solution that may sidestep a default, rather than the forced deals of other eras.

“There’s not any clarity here because people don’t know,” said Christopher Whalen, editor of The Institutional Risk Analyst.

“This is why the Europeans came up with this ridiculous deal, because they don’t know what’s out there. They are afraid of a default. The industry is still refusing to provide the disclosure needed to understand this. They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”

Regulators are aware of this problem. Financial reform packages on both sides of the Atlantic mandated many changes to the derivatives market, and regulators around the globe are drafting new rules for these contracts that are meant to add transparency as well as security. But they are far from finished and could take years to put into effect.

Darrell Duffie, a professor who has studied derivatives at the Graduate School of Business at Stanford University, said that he was concerned that regulators may not have adequately studied what contagion might occur among swaps holders, in the case of a Greek default.

Regulators, he said, “have access to everything they need to have. Whether they’ve collected all the information and analyzed it is different question. I worry because many of those leaders have said there’s no way we’re going to let Greece default. Does that mean they haven’t had conversations about what happens if Greece defaults? Is their commitment so severe that they haven’t had real discussions about it in the backrooms?”

Regulators aren’t saying much. When asked what data the Federal Reserve had collected on American financial companies and their swaps tied to European debt, Barbara Hagenbaugh, a spokeswoman, referred to a speech made by Mr. Bernanke in May in which he did not mention derivatives tied to Greece.

At the Wednesday press conference, Mr. Bernanke said that commonly cited data on derivatives do not take into account the offsetting positions banks have on their Greek exposures. And with those positions, he said, even if there is a Greek default, “the effects are very small.”

At the European Central Bank, Eszter Miltenyi, a spokeswoman, said: “This is much too sensitive I think for us to have a conversation on this.”

On Wall Street, traders are debating whether the industry’s process for unwinding credit-default swaps would run smoothly if Greece defaulted. The process is tightly controlled by a small group of bankers who meet in an industry group called the International Swaps and Derivatives Association.

But the smoothness of the process would be irrelevant if the risk were concentrated in just a few weak institutions.

The process is fairly well developed, but it has been little tested on the debt of countries. For the most part, Wall Street has cashed in on credit-default swaps tied to corporations’ debt.

For most purposes, determining whether a default occurred in a country’s debt falls to ratings agencies like Fitch and Moody’s. But for the derivatives market, a committee of I.S.D.A. makes the call.

If the committee decides there was a default, it passes the baton to Markit, which is partly owned by the banks. Markit holds an auction to determine how much value has been lost on the debt, and that determines how much money is paid out to the parties that purchased the insurance.

Marc Barrachin, who runs the auctions, said there was no reason to worry about the process.

“The process is very smooth, very well understood by market participants,” said Mr. Barrachin, the director of credit products at Markit.

“I mean if you go back to 2008 right in the fall, in five days we had auctions for Fannie Mae, Freddie Mac and Lehman Brothers, and two weeks after that you had Washington Mutual. I go back to that period of stress and the orderly settlements of large amounts of credit derivatives, for names that were widely followed, were testament of the efficiency of the auction system.”

In the case of A.I.G., there was not an unwind process run by I.S.D.A. because A.I.G.’s contracts were tied to mortgage bonds. Those sorts of derivatives pay out money over time, whereas derivatives tied to a country’s debt pay out on one occasion: if a default occurs. That makes sovereign derivatives more similar to derivatives on corporate bonds and different in some ways from the situation at A.I.G.

The uncertainty around how a sovereign default would course through the derivatives market had greatly increased the price premiums banks were charging to put on new derivatives trades related to European countries. 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, according to Markit.

“There is lack of transparency and visibility in these products, and that increases the risk,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman, a boutique banking firm in New York.



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