Cracks Beneath: China, Greece, US and Derivatives

Greece has a population of just over 11 million people. Compare that to the New York City metropolitan area population estimated at 18.9 million. It may seem strange that Greece’s travails might greatly affect the global economy, but the potential repercussions from a Greek default become more significant when considering leverage and derivatives. 

CNNMoney noted that data from the International Monetary Fund (IMF) show that German banks are heavily leveraged, holding 32 Euros of loans for every Euro of capital they have on hand. Other banks are leveraged to the hilt as well. Belgian banks are leveraged 30-1, and French banks are leveraged 26-1. Lehman’s leverage at the time of its collapse was 31-1.

U.S. Banks are paragons of sanity by comparison, with an average leverage of only 13-1.  France and Germany are the countries most exposed to Greek debt through bank and private lending and government debt exposure (Charts at Right & Below).
 

Derivatives present another potential minefield. As Louise Story wrote in the NY Times (Chart Below Added by EconMatters), 

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

Chart Source: NYTime.com



"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.”

Michael Hudson explored the differences between what happened to Iceland and its debt crisis, and what is currently happening in Greece.

“The bankers are trying to get a windfall by using the debt hammer to achieve what warfare did in times past. They are demanding privatization of public assets (on credit, with tax deductibility for interest so as to leave more cash flow to pay the bankers). This transfer of land, public utilities and interest as financial booty and tribute to creditor economies is what makes financial austerity like war in its effect...

“One must conclude that the EU’s new central planners.... are acting as class warriors by demanding that all losses are to be suffered by economies imposing debt deflation and permitting creditors to grab assets – as if this won’t make the problem worse. This ECB hard line is backed by U.S. Treasury Secretary Geithner, evidently so that U.S. institutions not lose their bets on derivative plays they have written up..."

In an interesting article, Brian Edmonds wonders whether the U.S. is too big to fail, linking the debt crisis in Greek to U.S. Money market funds holding large quantities of European debt.

“If Greece defaults, who will be holding the bag?... Recent publications have pointed, as one example, to the exposure of big U.S. money market funds that hold large amounts of short-term European bank debt.

“The biggest way that the risk of default is mitigated is through credit default swaps.... Sovereign debt swaps are the gorillas in the PIIGS room, but no one really knows if they are just 800-pound gorillas (large but manageable) or King Kongs (think AIG)....Only if, or when, Greece defaults will we know who ultimately has sold insurance against that default.”

China has now become Europe's de facto IMF and World Bank.  On Thursday, June 23, Qu Xing, director of the China Institute of International Studies, a Foreign Ministry think tank, told reporters that China doesn’t want to see debt restructuring in the Eurozone and is working with the IMF and countries involved with the debt crisis to avoid it.

China has so far sunk about $50 billion in bad money, and Wen Jiabao is now in the market for Hungarian bonds.  Speaking at a press conference during a visit to Hungary, Premier Wen Jiabao said,

“China is a long-term investor in Europe’s sovereign debt market. In recent years we have increased by a quite big margin holdings of Euro bonds. In the future, as we have done in the past, we will support Europe and the Euro.” 

Sunday, on a tour of the Chinese-owned Longbridge MG Motor factory in Birmingham, Premier Wen told BBC it will lend to European countries, and also has plans to stimulate domestic demand and reduce its foreign trade surplus.  Bailing out Europe is probably more of a priority for China than for the IMF.

We will see how China is going to juggle rescuing debt ridden Europe, battling rampant inflation, and the CNY10.7 trillion ($1.65 trillion) debt amassed by China's local goverments.

Meanwhile, the U.S. Dollar bounced off of a high of 76.3 on Friday, June 24, and settled at 76.1, reminding us that our levels are more like trampolines than like walls. We currently believe the Dollar is apt to go down this week, which should be bullish for the markets.

However, we are cashy and cautious again. Based on the premise that oil may be strong into the July 4 weekend, and the dollar may be weak, Phil Davis suggested a trade idea for going long USO:

This week $35/36 bull call spread is $0.61 and you can sell July $34 puts for $0.48 so that is a net $0.13 on the $1 spread. If USO makes it to $36 and holds it to next Friday, this can turn $650 cash into $5,000 (USO is now $35.83 with oil at $91.11).