Mauldin: US banks have plenty of euro exposure

Remember all that stuff about getting our deposit banking institutions out of the opaque derivatives trading business and back to, oh I don't know, banking?

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    A currency exchange employee changes euros and U.S. dollars in an exchange kiosk in downtown Milan, Italy, in this July 5, 2005 file photo. Right now, many G-20 governments hold each other's debt and trade each other's currency. Is this financial leadership or an ongoing game of kick-the-can?
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Remember all that stuff about getting our deposit banking institutions out of the opaque derivatives trading business and back to, oh I don't know, banking? Well the President decided to come into office in the midst of the worst economic crisis in 70 years and use up all his political capital to tackle healthcare instead.

So now, US banks are facing a not-insignificant amount of exposure to Europe via the kind of unquantified counterparty risk that should have been left behind in the last decade.

John Mauldin's latest, Kicking the Can Down the Road, opens with some detail about this exposure...

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How often did we as young kids go down the street kicking a can? "Kicking the can down the road" is a universally understood metaphor that has come to mean not dealing with the problem but putting a band-aid on it, knowing we will have to deal with something maybe even worse in the future.

While the US Congress is certainly an adept player at that game, I think the world champions at the present time have to be the political and economic leaders of Europe. Today we look at the extent of the problem and how it could affect every corner of the world, if not played to perfection. Everything must go mostly right or the recent credit crisis will look like a walk in the Jardin des Tuileries in Paris in April compared to what could ensue.

From the point of view of not wanting to so soon endure another banking and credit crisis, we must applaud the leaders of Europe. The PIIGS collectively owe over $2 trillion to European and US banks. German, French, British, Dutch, and Spanish banks are owed some $1.5 trillion of that by Portugal, Ireland, Spain, and Greece by the end of June, 2010. That figure is down some $400 billion so far this year, which means that the ECB is taking on that debt, helping banks push it off their balance sheets. For what it's worth, the US holds, according to the Bank for International Settlements, about $353 billion, or 17%, of that debt, which is not an inconsequential number.

Robert Lenzner notes something very interesting about the latest BIS report, out this week:

"What's curious, though, is that for the first time the BIS has broken out a new debt category termed 'other exposures, which it defines as 'other exposures consist of the positive market value of derivative contracts, guarantees extended and credit commitments.' These 'other exposures' - quite clearly meant to be abstruse - amount to $668 billion of the $2 trillion in loans to the PIIGS.

"So, bank analysts everywhere; you now have to cope with evaluating derivative contracts that could expose lenders to losses on sovereign debt. Be on notice!"

What did I write just last week? That it is derivative exposure to European banks that is a very major concern for the world and the US in particular. It is not just a European problem. I predicted in 2006 that the subprime problem would show up in Europe and Asia. This time around, European banks present a similar if not greater risk to the US.

A collapse of a major European bank could trigger all sorts of counterparty mayhem in the US banking system, at least among our major investment banks. And then people would want to know which bank was next. This is yet another reason why the recent financial-system reform was not real reform. We still have investment banks committing bank capital to derivatives trading overseen by regulators who don't really understand the risk. Who knew that AIG was a counterparty risk until it was? Lehman was solid only a month before until it evaporated. On paper, I am sure that every one of our banks is solid - good as gold - because they have their risks balanced with counterparties all over the globe and they have their models to show why you should go back to sleep.

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