Derivatives and bonds and crashes, oh my (European edition)

Bob Kuttner writes about the huge piece of the world economic crisis on the other side of the Atlantic in Europe on the Brink Huffington Post 10/23/2011:

Beginning in 2008, the collapse of Bear Stearns revealed the extent of pyramid schemes and interlocking risks that had come to characterize the global banking system. But Western leaders have stuck to the same pro-Wall-Street strategy: throw money at the problem, disguise the true extent of the vulnerability, provide flimsy reassurances to money markets, and don't require any fundamental changes in the business models of the world's banks to bring greater simplicity, transparency or insulation from contagion.

As a consequence, we face a repeat of 2008. Precisely the same kinds of off-balance sheet pyramids of debts and interlocking risks that caused Bear Stearns, then AIG, Lehman Brothers and Merrill Lynch to blow up are still in place.

And he explains the gerbel-wheel on which the EU's leaders decided to place themselves:

The Greek situation reveals the deeper potential for contagion, and the Ponzi scheme that now characterizes the banking system. Europe's banks hold some in $121 billion Greek government bonds that are trading at about 40 cents on the dollar. Europe's leaders, meeting in a summit conference over the weekend, admitted that Greece needs a reduction in its debt load of 50 to 60 percent, and not the 21 percent that was agreed to by the banks back in July.

So Europe's banks will need to take much a bigger hit, and it's not clear that they have the capital to sustain it. But Europe's governments and the European Central Bank are balking at providing this money directly. Instead, they hope to double down with a bailout fund, the $606 billion European Financial Stability Facility that, in effect, borrows against the credit of Europe's soundest economies.

Kuttner comes up with a nice turn of phrase here:

The banks' own shaky condition makes them risk-averse about holding not just Greek sovereign debt, but also the bonds of Portugal, Ireland, Italy and Spain.

The financial industry has coined the acronym PIGS to denote these nations, implying that the crisis is their own fault for living beyond their means. But the true pigs of the story are the banks.

It gets dizzying, but these bank policies are putting the world's economy at risk. As Kuttner explains, banks holding Greek and other now-dubious sovereign debt have used derivatives (interest-rate swaps, in this case) to insure themselves against losses. When they have to take those losses, the insurance provided by the derivatives will kick in and create new problems for the banks that provided the derivatives. Something very similar to that is what happened with AIG's collapse.

Kuttner is also good on this point:

Euro-skeptics are saying, "We told you so" -- the Euro was always a doomed idea. It's true that creating a monetary unit to be used by 17 separate nations with diverse economic strengths and budgetary conditions was a risky proposition. The Euro was a vessel designed for calm seas, not for once-in-a-century storms.

But to solely blame Europe and its institutions is to excuse the source of the storms. That is the political power of the banks to block fundamental reform.

Democratic government should be providing the offset to the power of the financial institutions. And in that sense, in the US and most of Europe, our governments are failing badly on their responsibilities to the people.

Tags: robert kuttner, world economic crisis