Dangerous dominoes: what lies beyond a Greek tragedy

Everyone is talking about Greece but ignoring that elephant in the room – Italy. How much is actually at stake as the Eurozone fiddles while its countries burn?

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If Greece goes, taking the obvious candidates with it, who's next?
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Simon Miller
On 4 November 2011 12:18

What happens when you cross a Greek tragedy and a drawing room farce?

I don't actually know. But I can bet that it looked a lot like the events in Cannes this week where the Greek Prime Minister, George Papandreou was hauled in front of the parents, the Merkozys, and scolded for daring to introduce a bit of direct democracy to the birthplace of, erm, democracy.

Yeah, he was game playing; probably hoping for a better deal on the bailout. But it is telling that European leaders twisted and turned trying not to criticise the idea of giving the people a say at the very time that there is a significant democratic deficit at the heart of the euro project.

And our boys are not much better. Fresh from annoying their own backbenchers, Gideon (George to us common folk) and David have now announced that there will be more money going into the International Monetary Union.

This is the politics of the nuthouse. You don't reward a naughty child by giving it sweets and you certainly shouldn't be giving even further monies to go into the unreconstructed hole that is the Eurozone.

But, they cry, it doesn't go to save the Euro, it goes to individual countries. I'm sorry but enough of the weasel words. This is a bailout of the Eurozone, pure and simple and unless there is structural reforms, either through defaults or true federalism, this money will simply feed the flames not extinguish the fire.

Looking at the numbers it is quite easy to see why this panic has set in; how the interconnection threatens everyone. 

In terms of net exposure, if Greece goes then French banks will be liable for £33.8bn while Germany will be exposed for £11.9bn. Meanwhile, UK banks have a £0.62bn exposure.

So far, not as bad as presumed.

However, there is that great, steaming, grey, leathery-looking thing in the room: Italy.

The Merkozys, along with Uncle Sam, browbeat naughty-boy Berlusconi into agreeing a room inspection to make sure the Italian parliament is tidying up.

Its borrowing costs hit a euro-high of 6.343 percent yesterday bringing it ever closer to the seven percent point of no-return where Italy would have to borrow more just to service the interest on its loans rather than pay anything back.

It’s like an interest-only mortgage: although you are paying the bank £100 a month, you still owe it for a £300,000 mortgage.

And it was at 7 per cent where Portugal and Greece sought bailouts. However, with Italy being Europe’s third largest economy, it is extremely doubtful that there is enough money in the coffers to save it.

Again, returning to the figures, French banks have £229.3bn in net claims while UK institutions have £16.3bn exposure and Spanish banks are owed £6.2bn.

So what? you may ask. It’s just the banks. Well, no, not really.

According to Bank for International Settlements (BIS), French public sector exposure to Italy comes in at a huge £66.9bn. Even in the UK, this net exposure comes in at £10.8bn. Imagine the impact that exposure would have on services if Italy went bust.

And, unfortunately it doesn’t stop there. So Greece goes and then Italy, our banks would be OK wouldn’t they with their 10 per cent and more capital ratios?

Unfortunately this is where France comes into play. The chain is expected to go G.I.P.S. and then probably Ireland but if those two countries go, French banks would follow.

Creative accountancy aside, it is not in a very healthy place at the moment. And our banks have a £100.5bn direct gross exposure to France – making a net of £13.8bn. It is that serious.

But what about credit default swaps (CDS)? Surely they are designed to protect against this type of event?

Well, there are huge exposures in extended guarantees. For instance, the UK has a total of £818.6bn in other potential exposures across European banks in the forms of derivatives contracts, guarantees extended and credit commitments.

In fact there is a very good reason why the US is keeping a closer eye on the Eurozone.

Not only does US’ exposure to European bank debt stand at $705.6bn (£442.1bn), US insurance against credit loss in Greece, Portugal, Spain, Ireland and Italy actually increased in the first half of the year by $80.7bn to $518bn, accounting for two-thirds of the total sold on these territories.

Now, issuers will rightly point out that there are hedging strategies and insurance against counterparties.

However, all it takes is a sovereign default and a run on periphery debt triggering collateral calls for the sellers of the CDS. All it would take is one or two not meeting the margin calls.

Basically, a bank sells protection to another bank while buying protection from others. What will happen to that bank if those they bought protection from cannot pay up? 

The risks are that serious. If Greece goes, Italy goes and so on. With huge exposures in the US and Japan (Italian net exposure of $39bn), the contagion could go global very quickly.

Yes this is a European problem and it is up to the Europeans to sort it out but at the moment they are just blowing on the flames in the hope that it doesn’t spread to another part of the house.

Meanwhile, Uncle Sam and others had better hope that the Eurozone builds a firewall, very quickly, before the fire spreads down the street.

Simon Miller is the Editor of Financial Risks Today. He tweets at @simontm71 

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