Banks Bracing for 2012 Euro Financial Apocalypse

As the European debt crisis threatens to spiral out of control, banks are scrambling behind the scenes to protect their balance sheets and hedge their exposure to ride-out an increasingly scary 2012.

But while some of the moves may help mitigate the losses from Armageddon, market watchers say certain financial insurance policies — particularly credit default swaps on sovereign debt — may not work in a new financial crisis.

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Banks are loading up on hedges against a possible European financial collapse. The notional amounts outstanding of over-the-counter derivatives rose 18 percent in the first half of 2011 to $708 trillion as of June 2011, a record high, according to a report by the Bank of International Settlements released Wednesday. In the second half of 2010, the notional value rose only by 3 percent.

Over the counter derivatives are private agreements between parties, different from derivative contracts that are traded through exchanges. The notional value of contracts provides a measure of market size, but not the actual measure of the value that is at risk among participants.

"Given all the increased volatility — the unusual conditions with the dollar and the euro, the debt crisis in Europe, the debt problems of the U.S. — you are seeing an increase in hedging," says Steve Wyatt, professor and Chair of the Finance Department at the Farmer School of Business at Miami University, Ohio. "The more astute observers in the market have come to the conclusion that the ECB will not buy enough paper to change the market view on this because of inflation fears. The only way out of this is fiscal integration or some modification of the membership in the Euro. That is not going to be quick or clean. That is the risk participants are hedging against."

Worries that some risks cannot be hedged away or that some hedges will prove ineffective have, however, dogged the stocks of Citigroupand Morgan Stanley, and other large banks, even as they strive to be more transparent with their disclosure and insist that their exposure to the peripheral zone in Europe is "manageable."

Here's a quick snapshot of their exposure and hedges purchased, according to latest disclosures.

Citigroup has a net funded exposure to Greece, Italy, Ireland, Portugal and Spain of about $7.2 billion. That figure has been arrived at after netting out hedges worth $9.2 billion and margin and collateral of about $4.1 billion. In addition, Citi has $9.2 billion in unfunded commitments to the region.

Morgan Stanley said it had $2.1 billion in net exposure to the troubled five countries and $5.7 billion in gross exposure.

Goldman Sachshas a gross exposure of $4.16 billion and a net exposure of $2.46 billion.

Bank of Americahas a gross exposure of $14.6 billion and has purchased credit protection worth $1.65 billion

JPMorgan Chasehas a gross exposure of $20.3 billion and a net exposure of $15.1 billion after netting hedges worth $5.2 billion.

Banks say net exposure is a better estimate of the amount of money that is actually at risk. Investors are, however, focusing on the "gross" exposure, which excludes the impact of hedges, because they worry about the potential failure of counterparties on the other side of the transaction and their inability to honor their agreement.

Another risk to hedging strategies that has emerged since the crisis is "voluntary" debt forgiveness that has rendered CDS ineffective as an instrument. European policy makers wishing to avoid an outright default in Greece are asking bondholders to voluntarily write down 50 percent of their debt . While bondholders take a loss, however, they will not be compensated by the seller of the CDS because they took a voluntary writedown.

If this becomes prevalent as the contagion spreads and governments prevent insurance on debt to be paid, all the CDS purchased so far would prove ineffective.

Fitch highlighted the risk of unviable hedges in its report Wednesday on European exposure of U.S. banks. "While U.S. banks have hedged part of their European exposures through the credit default swap (CDS) market, this tactic could prove problematic if "voluntary" debt forgiveness becomes more prevalent and CDS contracts are not triggered. Any cross-country hedges or proxy hedges (such as an index) could pose mismatch risk/poor hedge performance."

Russ Chrusciel, product manager, SunGard's Global Trading business, believes that anxiety over the effectiveness of such CDS and the desire to make some offsetting purchases might be one reason that is driving the increase in hedging activity. "The amount of OTC derivatives outstanding may very well have increased as firms who had positions in miscellaneous credit default swaps (CDSs) across European countries sought additional protections in the marketplace...largely because the 50 percent haircut to Greek bonds did not trigger payout on these pre-existing credit default swaps."

He believes market participants might be looking to buy other forms of protection that have clearer terms.

Then there are some risks that cannot be hedged. "How do you hedge against a nation as big as Italy? There is no counterparty that is credible enough to take on that risk," says Wyatt.

At the end of the day, he says, "the aggregate risk hasn't changed. All you are doing is transferring the risk. Someone else now is probably twice as risky. You are able to eliminate the risk from your portfolio but not from the economy."

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