Washington Post Europe’s debt crisis and the danger we can’t see By _Matt Miller_ (http://www.washingtonpost.com/matt-miller/2011/02/24/ABBcOYN_page.html) , Published: October 26, 2011 There are plenty of reasons to be freaked out by the banking and sovereign debt crisis _now reaching a crescendo in Europe_ (http://www.washingtonpost.com/business/economy/europe-struggles-toward-rescue-plan/2011/10/25/gIQAoGZ FGM_story.html?hpid=z3) . But one factor that’s gotten little attention could turn this Very Bad Situation into a True Calamity. It’s this: Regulators here and in Europe have no idea — repeat, no idea — of the full extent of the derivatives exposure that could be triggered by an “official” Greek default, or by the failure of a major French bank. And if the people in charge have no clue as to the fallout from what may be trillions of dollars in side bets waiting to be triggered in a catastrophic cascade, they’re basically flying blind. If it strikes you as insane that officials don’t know the exposure of these derivatives, given the havoc these “financial weapons of mass destruction” wreaked last time, you’re thinking clearly. The idea that we could be back on the edge of a Lehman/AIG-style implosion, just three years after the near-death experience of 2008, defies all presumptions about the human species’ capacity for learning. But then, Darwinian optimism leaves little room for the greed and myopia driving the global banking lobby today — or for the industry’s destructive power to kill or defer common-sense reform. Remember, it was always odd that problems in the relatively small market for subprime mortgages could have brought the global economy low. The reason they did was because these subprime woes were massively amplified by trillions in side bets placed on these mortgages via exotic derivatives. “Naked credit default swaps” allowed parties with no interest in the underlying mortgages to place huge bets on whether borrowers would or would not perform. Fear of the explosive power of this casino — and its hidden concentration in a reckless, “too-interconnected-to-fail” giant like AIG — led U.S. officials to cough up no less than $180 billion in taxpayer money to pay off these bets in full. These officials, fearing a meltdown, treated sophisticated derivatives traders exactly as they would treat innocent consumer depositors in a failing bank, as people to be protected at 100 cents on the dollar. It was, and is, grotesque. Today, Greece’s economy is roughly the size of the economy of Massachusetts. The notion that its debt problems could bring down the global financial system seems absurd. Except for two things. First, many European banks holding Greek debt are so thinly capitalized (another way of saying “so imprudently managed”) that even tiny Greece’s default could wipe them out. Yet Europe’s emerging plan to cover this capital shortfall is tragically inadequate. As Douglas Elliott, a former investment banker now at the Brookings Institution, _points out_ (http://www.brookings.edu/testimony/2011/1025_euro_crisis_elliott.aspx) , the plan to _add 100 billion euros in capital_ (http://www.businessweek.com/news/2011-10-20/austria-says-europe-banks-need-100-billio n-euros-of-capital.html) represents a 10 percent capital boost for the top 90 banks, which have about a trillion euros in capital today. But since they also have around 27 trillion euros in assets, this new capital would protect them against a further decline of less than half a percentage point in the value of their assets. In other words, this is not a serious plan. Yet the derivatives black hole makes matters worse. Exactly how much worse? We don’t know, because the big banks don’t have to disclose this information. The derivatives markets’ opacity is precisely what lets banks make a killing. If such trading becomes transparent and standardized, bank profits from derivatives will plummet. So they resist. Even more outrageous, the chief negotiator for the banks being asked to take a deeper loss on their reckless loans to Greece uses this unknown derivatives exposure as a negotiating ploy. “Nice little global economy you’ve got here,” he’s basically saying. “Be a shame if something bad were to happen to it, if you make us say there’s been a ‘default.’ ” To be sure, in the United States, once the Dodd-Frank implementing rules are written, traders will have to disclose a good chunk of their derivatives activity sometime in . . . 2013. A bit late for today’s crisis, but there’ s always the next one. In the meantime, U.S. officials obviously talk to the banks they supervise. I’m told they have a better sense of U.S. banks’ derivatives exposure than was the case in 2008, and that they’re not frightened by what they see. But taking comfort here requires one to believe that banks are telling regulators the truth today, and that they actually know their own risk positions (which even their CEOs didn’t understand in 2008). Even then, you can take comfort only if you think U.S. banks are the major holders of the relevant derivatives, when it’s almost certain that European firms are. And analysts tell me the Euro-banks’ books are monuments of deceit that make our own banks’ faulty financial statements look like models of truth in accounting. Where does that leave us? There are more than $22 of derivatives for every dollar of goods and services produced in the U.S. economy. Some of these are harmless hedges; others, bombs waiting to detonate. Nobody knows. As one hedge fund manager told me: “All the bad lending is like a keg of dynamite, and all of the derivatives are like little fuses running from one house to another to another, and in each house is another keg of dynamite.” One thing is certain. If it all goes kaboom, the banking elites who’ve sniffed dismissively at Occupy Wall Street ain’t seen nothing yet.
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