The market is about ready to slap ECB president Jean-Claude Trichet smack across the face with a hard dose of reality regarding Greek debt restructuring.



Please consider Greek Rescue Package May Be Delayed by EU Disagreements on Investors’ Role

An emergency session of finance ministers in Brussels late yesterday failed to reconcile a German-led push for bondholders to shoulder part of the cost of a new Greek aid package with European Central Bank warnings backed by France that the move might constitute the euro area’s first sovereign default.



Yields on 10-year Greek bonds touched 17.46 percent yesterday, a record in the 17-nation euro area’s history.



Finance ministers including Elena Salgado of Spain and Didier Reynders of Belgium stressed that any decision must satisfy the ECB’s concerns. Luxembourg’s Jean-Claude Juncker, who leads the group of euro-area finance ministers, said before the meeting that “all options” would be considered.



Germany and France, Europe’s two biggest economies, are on opposite sides of the dispute, with France indicating backing for the ECB’s view. While French Finance Minister Christine Lagarde has ruled out any action that constitutes a “credit event,” her German counterpart, Finance Minister Wolfgang Schaeuble, said June 10 that Europe’s biggest economy “has to insist on the participation of the private sector” in Greece.



Schaeuble said yesterday’s meeting produced “no result.”



Greece’s ports, banks, hospitals and state-run companies will grind to a halt today as the two biggest labor unions call the third general strike of the year to oppose Prime Minister George Papandreou’s budget cuts and asset sales. About 1,000 protesters were demonstrating in front of the Parliament today.

ECB's Nuclear Bluff Revisited

Restructuring of sovereign debt in Greece would make it impossible for the European Central Bank to continue using its bonds as collateral in liquidity operations, Executive Board member Juergen Stark said.



“Sovereign debt restructuring would undermine the eligibility of Greek government bonds,” an ECB spokesman quoted Stark as having said during a visit to Greece on Wednesday.



“A continuation of liquidity provision would be impossible.”



ECB Executive Board member Lorenzo Bini Smaghi said on Wednesday that even a soft restructuring of Greek debt would have devastating consequences. He slammed talk of a so-called “soft restructuring” of Greek debt as “empty slogans.”

Empty Slogans

Prepare for Downgrades of French Banks

BNP Paribas SA, France’s biggest bank, and local rivals Societe Generale (GLE) SA and Credit Agricole SA (ACA) may have their credit ratings cut by Moody’s Investors Service because of their investments in Greece.



Moody’s placed the three banks’ ratings on reviews that will focus on their holdings of Greek public and private debt “and the potential for inconsistency between the impact of a possible Greek default or restructuring and current rating levels,” the ratings company said in a statement today.



Ex-IMF Chief Raghuram Rajan on "Containment

"One of the advantages of this long drawn-out crisis resolution process is that many private sector entities that were exposed to Greece have reduced their exposure," Rajan told reporters on the sidelines of an investment conference in Singapore.



"The extent to which banks in Europe are exposed to Greece is much more limited than it was, even say, six months or a year ago, and so the cost of a Greek default and restructuring could be absorbed by the banking sector," he said.



Rajan said a restructuring of Greece's debt looked increasingly probable as Athens lacked the political will to carry out widespread privatizations of state assets and budget tightening.



"If it (the debt restructuring) happens in a way that banks and markets are prepared for, even if not publicly but at least privately, it is very well containable," he said.

Containment Nonsense

Divorced From Reality

Greece, shut out of the capital markets, needs money, and soon, and is willing to play along with the fiction that the next tranche of aid, perhaps 90 billion euros, from the European Union, International Monetary Fund and ECB will buy them enough time.



The ECB, which is up to its eyeballs in exposure to Greek debt, steadfastly maintains that it won’t countenance a soft restructuring, or default, presumably because it fears this will be too much for it, the banks, and the global financial markets to bear.



Germany, however, is insisting on just that; it maintains that the private sector will have to bear some of the costs, and while there is much discussion about “soft” restructurings featuring debt repayment extensions, no one has credibly explained how the private sector can take its lumps without it being considered a default.



The ECB has perhaps 40-50 billion euros’ worth of Greek bonds on its balance sheet, and has lent about another 90 billion or so to Greek banks. It has threatened, in the event of a restructuring, to stop accepting Greek debt as collateral, a move that would be tantamount to cratering the entire Greek banking system at once. This would also deal sharp losses to the many euro zone national central banks which are exposed, potentially causing some to need additional capital.



By destroying the Greek bank sector, the ECB would, quite possibly, effect the exit of Greece from the euro zone. Depositors in Greek banks understand this, and have been withdrawing funds.



Given all of this, it seems likely that the ECB will relent, though in doing so they will seriously impair their credibility. And of course, as soon as Greece defaults, the eyes of the market would immediately turn to Portugal, Ireland and even Spain.



Rather than figuring out how to keep Greece upright without knocking over the banks, they would have been far better off figuring out how to actually make the banking system solvent and sound given Greek insolvency. That would involve huge private sector losses, inevitably, but might just have laid the groundwork for sustainable growth.



Instead we will have a sinking euro and waves of deflationary force coming out of Europe.

What is US Exposure to the EU Mess?

The Street Light

As last week's new BIS data showed [see Betting On the PIGs], it appears that US banks indirectly have substantial exposure to the peripheral Euro-zone countries that are teetering on the edge of bankruptcy. Exactly what form that exposure takes is a bit uncertain, though it seems likely that much of it is in the form of credit default swaps (CDS) written by the US banks to provide insurance against default to the holders of bonds from Greece, Ireland, and Portugal.



But it's a bit frustrating not to have a clearer understanding of exactly what form this exposure takes. So I've been trying to see if there is any public information that can give us a hint about exactly how the big US banks have incurred such exposure.



Unfortunately, it's very difficult to get any good information about banks' derivatives exposures. The major US banks tend to downplay their exposure to the Euro debt crisis in their SEC filings.



In fact, B of A's direct exposure to Greece is listed at only about $500 million. But note that that is their direct exposure. What we learned from the BIS data is that they also have indirect exposures, which probably arise primarily through their credit derivatives purchases and sales.

1. Bank of America, Morgan Stanley, and Goldman Sachs are the most aggressive in terms of taking open positions on default outcomes. But we have absolutely no idea how much of those positions (if any) were with peripheral Euro assets. Also, while the last two firms don't break out income attributable to CDS activities (at least not that I could find), B of A made a huge portion of their profits in 2010 from them. (Note that Citi did not indicate how much of the CDS protection that they sold was covered by purchases of CDS insurance, so they may or may not be in that list as well.)



2. The aggregate CDS exposures of the big US banks are certainly large enough to be plausibly consistent with the BIS estimate of about $100 bn in indirect exposures to peripheral Europe. If you add up the highlighted numbers (and make a guess at Citi's position), it seems reasonable to guess that the total net open positions on CDS protection sold to third parties by the big US banks is between $1,500 and $2,000billion. Attributing $35 bn of that (about 2%) to Greece, which has certainly had one of the most active markets (proportionally) for CDS contracts over the past year, doesn't seem to be a stretch.



3. Banks do not have to provide much detail about the indirect credit exposures that they take on when they sell default insurance through the CDS market. We have incredibly scant information about the positions that US banks take through default insurance, and therefore no idea about how any individual bank will be affected by a Greek default.



Finally, a note about the risk this poses to the US banking system. The big US banks are well-capitalized now, and can fairly easily absorb losses of several billions of dollars in the event of a Greek default. But two serious concerns remain. First, I fear that this may have the potential consequence of exacerbating the flight to safety that will happen in the event of Greece's default; if you have no idea who is really going to be on the hook and ultimately liable for CDS payments, your best strategy may be to trust no one. I don't think that triggering post-traumatic flashbacks of the fall of 2008 is going to do good things to the market or the economy. Second, I wonder if there's a public relations disaster just lying in wait for the big US banks. After all, how will you feel (assuming you don't work on Wall Street) when you read the headline that Big Bank X lost money because it sold billions of dollars of credit default insurance while it was on taxpayer life-support? Rightly or wrongly, I'm guessing that Big Bank X will not be very popular for a while.

Bank of America Daily Chart

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JPMorgan Daily Chart

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Derivatives and Off Balance Sheet Mess

More Fundamental Question