The Real European Crisis Explained

To begin the year I wrote a seven part outlook discussing my thoughts on what 2011 would look like for the financial markets.  One of the parts was the 2011 Outlook: Sovereign Debt, which has been my most viewed post of the year by far due to the tremendous amount of viewers from outside the United States, specifically Greece.

The outlook has tracked events closely as they have taken place over the past 9 months.  (The major difference is that I thought Spain would be targeted by the bond market before Italy.  Italy moved ahead in the sovereign debt race to collapse, but I am confident Spain will soon have its moment in the spotlight)

While the sovereign debt crisis was barely a news event back in January, it is the focus of every financial story today.

The initial shock to the system came in the form of the bonds for the European countries, it has now moved into the second stage: the toxification of the banking system.

Most analysts and investors assume that the greatest danger facing the European banking system is the write downs that will be needed to occur when Greece defaults.  That is a major worry moving forward, but it is a visible danger that banks can see and do their best to work around.

However, behind the scenes in the shadows, there is another hidden danger lurking.  Its unseen nature makes it far deadlier because our financial system is based on trust, or "known knowns" as they are called on a trading floor.

This force has arrived in the form of Credit Default Swaps, or CDS, as you may have read about in the news recently.  Yes, this is the old friend that destroyed the US banking system back in 2008.

A Credit Default Swap is insurance an investor takes out against default on a bond.  They are usually used as hedges to balance a complete portfolio against risk.  For example, if you own $1,000,000 in Greek government bonds, a few months ago you would have been wise to take out an insurance policy to hedge against the possibility of Greek bonds going into default. (I could use a far more realistic and complicated example but this makes it easier for those new to the discussion)

Here is the problem:  CDS contracts are a form of derivatives, meaning they are far less regulated than typical investment options.  They are usually "off balance sheet" items that can stay hidden from both the public and regulator's eyes.  It is the wild west of investing.

To compare 2008 to the present crisis, we understand who Lehman brothers is.  It is Greece.  We can clearly see the danger and insolvency.

What we cannot see is who the AIG is.  Who is the insurance company guaranteeing the debt against default?  It could be a major bank, or it could be a large hedge fund.  Some entity or a large group of entities are holding an enormous amount of Greek, Portugal, Ireland, Spain, and Italian bond insurance.

And the hurricane is about to hit.

Because banks cannot see who the AIG is, they are now looking around and not trusting anyone.  This is causing the financial system to freeze, just as it did in 2008.  The banking system is based on trust.  Most of the lending takes place overnight in something called the repo market.  However, banks now fear that they may wake up tomorrow morning and if the Greek CDS contracts have been triggered, their money would have been left at Lehman brothers the morning of the bankruptcy.

This then triggers another massive round of losses and write downs.

What is most fascinating, and troubling for those who understand how the system works, is that a hedge fund with very limited capital has the ability to write an unlimited amount of insurance (CDS) contracts in the unregulated derivatives world.  (Imagine a hedge fund writing an unlimited amount of home owner insurance contracts for homes on the coast of Florida to protect against a hurricane)

Every year for the past 5 years they have collected and made huge premium income on the monthly payments for this insurance.  If the hurricane hits, which is about to happen in the financial markets, these hedge funds can then just close their doors and walk away with the millions and millions in income they made during the past 5 years.

The taxpayer will then be left to make the banks whole.  This is coming, and it is important to understand it before it takes place so you are not fooled by a politician explaining to you the importance of "saving" the financial system.

Get ready for turbulence ahead.  When the first domino falls, it is going to trigger a panic.  You need to have some ammunition (cash) ready to purchase strong assets that will be going on sale.

When the time comes to buy, I will review exactly where I feel the opportunity is greatest.