The Guest Blog

Rating Agencies Are the Least of Europe’s Problems

Ivory Johnson |Scarborough Capital Management, Inc

One might argue that Greece technically defaulted when it could no longer borrow money from the capital markets to meet its obligations. Much like optimistic children who faithfully believe new sneakers make them run faster, the European Central Bank has engaged in fiscal gimmicks to delay the inevitable.

It would appear that the rating agencies have reached a similar conclusion, threatening to assign a default status to Greek debt if the ECB embraces a plan to roll over maturing bonds.

France built the Maginot Line during World War II, an impenetrable wall supported by heavy artillery and 15 percent of the French army. Despite their efforts, Adolf Hitler went around the wall and conquered Paris without much opposition.

The French find themselves in another awkward predicament, proposing that banks voluntarily roll over as much as 30 billion euros in Greek debt that comes due over the next three years into five- or 30-year securities.

Once again, their plan was foiled when Standard & Poor’s declared over the weekend that either option would constitute a selective default.

Lost in the irony is the fact that Standard and Poor’s is the least of their problems. To be sure, a default assessment by all major rating agencies would make Greek bonds ineligible for use as collateral at the ECB, an indelible buzz kill for version 2.0 of the bailout plan.

It’s important to note, however, that the I.S.D.A. determines which events trigger a credit default swap independent of the rating agencies, creating an entirely new set of concerns.

According to Markit, the gross exposure of a Greek default is estimated to be $78.7 billion, while exposure to the PIIGS totals $616 billion. Naturally, there are more exotic derivatives that cannot be accounted for.

View over the caldera of Santorini in Greece.
Tom Pfeiffer | Getty Images

Keep in mind that the crisis of 2008 was magnified when banks used credit default swaps to insure mortgage backed securities. As luck would have it, AIG was the counter-party to many of these derivatives and couldn’t afford to pay the claims.

Even the bookie from Brooklyn takes both sides of the bet, but the masters of business administration at AIG found themselves overextended and unable to pay off on contracts, forcing the government to bail out the company with $182 billion and save the large banks whose survival suddenly depended on a balance sheet of CDO’s that weren’t properly insured.

The German and French banks have a $240 billion exposure to Greek and Irish debt. Moreover, half of all money market funds are invested in European banks. While these institutions may very well have hedged their balance sheets with credit default swaps, nobody knows if the derivatives are concentrated among a select few counter parties or whether they can even pay the claims.

Just as nobody would doubt that Barry Bonds used performance-enhancing drugs, few investors are willing to bet large sums that Derek Jeter is clean.

Should the I.S.D.A. trigger the credit default swaps, any hint that a contract cannot be fulfilled would immediately devalue the underlying security, whose owners may sell in a disorderly fashion once they realize their hedge is uncertain.

The price to insure against default on $10 million of Greek debt is $1.9 million per year, up from $775,000 a year ago. If you’ve ever seen a mafia movie where they muscle their way into a neighborhood restaurant, buy tons of fire insurance and then burn the place down, understand that the capital markets created an environment where irresponsible countries like Greece could borrow money at attractive rates, using currency swaps to circumvent the Maastricht Treaty, only to profit when Athens inched closer to insolvency.

Years ago, the best and the brightest became judges, engineers and professors, but multi-million dollar bonuses are hard to turn down. The next thing we knew, MIT math majors were creating reverse repo mortgage backed securities and floating interest rate swaps that the bottom third of the class couldn’t regulate or explain to their middle class clients.

Institutional investors and hedge funds have simply gone around the regulatory walls to reap huge profits by engaging in derivative trading, the kind that regulators and politicians lack the cerebral capacity to address.

To be fair, it’s never about the cover up; it’s not understanding the crime that leads to a crisis.

Ivory Johnson is the director of financial planning at Scarborough Capital Management, Inc. He is a Certified Financial Planner, a Chartered Financial Consultant and a frequent guest on CNBC. Mr. Johnson attended Penn State University, where he received a Bachelor of Science degree in finance.