Euro-Debt Threat to U.S. Banks Big But Unlikely
JPMorgan Chase & Co.'s net exposure to the sovereign debt of financially troubled countries is just $15 billion. At Goldman Sachs it's a paltry $1.5 billion. Bank of America's is under $17 billion and Citigroup has $22 billion.
Each company has trotted out these figures to imply that it could brush off a sharp deterioration of Europe's debt troubles without breaking a sweat.
It's a claim that few are buying, as analysts indicated during the companies' second-quarter earnings calls. Despite a Thursday night deal that paves the way for a "selective" Greek default, and reiterates Europe's support for its common currency, uncertainty remain concerning the question of whether nations on the Continent's periphery can balance their budgets and pay their bills.
While the exposure is real, market participants appear to be giving scant credence to the prospect that big U.S. banks will suffer debilitating losses at the hands of European borrowers. Instead, as Europe's sovereign debt crisis has progressed with fits and starts, investors appear to have lumped the threat of default-related losses into the same category as a prospective failure by the U.S. to raise its debt ceiling: too potentially disastrous to take seriously.
"People just feel that it will be solved, that the governments are not going to allow anybody to fail," said Paul Miller, a managing director at FBR Capital Markets. "At some point, they'll come up with something because the powers that be can be very creative."
Observers need not look far back for an example of how contagion could play out. Defaults even on Europe's periphery could quickly ensnare U.S. institutions in money market runs, interbank lending rate spikes and a collapsing repurchase market for short-term collateralized loans. A similar chain of events took place in the wake of Lehman Brothers' collapse.
"When there's contagion fear, you quickly get to a full-fledged crisis like Lehman," said Bill Longbrake, former chief risk officer of Washington Mutual and an executive in residence at the University of Maryland's School of Business. On just the money market issue, "if there wasn't a full backstop, all holy hell would break loose."
Money market funds are perhaps the easiest route to systemic troubles. The Securities and Exchange Commission's tweaks to the funds' investing rules require shorter average durations and greater disclosure than in the past.
Still, the funds no longer enjoy their crisis-era government guarantees and have gone abroad in pursuit of yield. Fitch concluded in March that short-term paper from European banks, many French, accounted for 44% of the top 10 prime money market funds' $736 billion in holdings. Those positions are widely known, and the money market fund industry has vehemently defended their soundness.
"French banks have much higher required capital ratios than Lehman Brothers did in 2008," the Investment Company Institute, a fund industry lobby, stated in June. "These are large, profitable banks, and their direct exposure to Greek government debt is a small fraction of their capital."
With the largest money markets offering yields below 0.1%, however, any level of doubt about the stability of European banks or the quality of their short-term debt could have a two-pronged effect.
First, money market funds might refuse to roll over existing debt to troubled institutions (as they did with Greece more than a year ago), cutting off suspect banks from a major short-term credit market. Money market investors, meanwhile, would have to decide whether to continue trusting the money market industry.
Given the recent example of the Reserve Primary money market fund, where breaking the buck precipitated industry-wide withdrawals, it is entirely possible that investors would again rush to the exits in the absence of government guarantees. Those withdrawals would result in diminished short-term lending capacity, producing even greater stress.
Interbank lending markets would face turbulence due to similar concerns over counterparty risk. Banks in the increasingly less peripheral countries under stress, as well as those heavily exposed to them, could be cut off by other institutions as a precaution. Unsecured interbank lending rates would then likely spike, as they did following Lehman's demise, when overnight interbank rates hit 6.9%.
This scenario would likely not be a direct concern for bank liquidity, either in the U.S. or Europe, as government entities stepped in to provide short-term funding. In Europe, much of the support needed in dollars would come from the U.S. through an untapped $750 billion swap line with the European Central Bank established when the Greek crisis came to light in May of last year. (The line is set to expire on August 1.)
"The Fed has its contingency plan in place, and the ECB would step up," Longbrake says. "The mechanics are pretty straightforward, and the intent would be that as more information comes to the table, people will eventually calm down."
If that process took only a few days, the economic damage would be minimal, Longbrake says. But for the freeze to lift, U.S. banks would have to become comfortable with European banks' exposure to sovereign debt and each other – something that is unlikely to occur rapidly, given the sketchy quality of information about exposure, Longbrake said.
Given how much controversy has surrounded even the EU stress tests, it would be more reasonable to expect the spike in interbank rates to persist, suppressing lending in the real economy in the U.S.
"U.S companies that require liquidity will come back to U.S. banks," says Sabeth Siddique of Deloitte & Touche LLP's risk management practice and a New York Fed bank supervisor during the 2008 crisis. "Confidence levels in general are going to go down, making things more expensive for everyone."
Secured short-term lending in the repurchase market would also get hit. Any sovereign debt considered unsafe would become ineligible for use as collateral, and haircuts on even high-quality collateral would rise. (This also would be an echo of what happened in 2008, when mortgage-backed collateral was frozen out and institutions began demanding a margin of safety on loans secured by U.S. treasuries.)
With liquidity in short supply, hedge funds and others dependent on bank funding for leverage might be pushed into fire sales, exacerbating pricing and liquidity concerns.
Since the near-meltdown of the repurchase market in 2008 helped spark U.S. government intervention, industry groups and the New York Fed have worked to make the system more secure. Inter-day credit risks have been limited, reducing the possibility of a run on a tri-party repo provider. Collateral requirements are stricter, and transparency into the quality of collateral is improving.
But should the stability of large European banks become suspect, even researchers at the entity overseeing the market don't expect they would afford much protection.
While the changes to repos are "substantial improvements," a New York Fed white paper concluded last year, "These recommendations will not make tri-party repo financing 'stable' in the face of events that give rise to concerns with counterparty credit standing."
The interrelated channels of interbank lending, repo, and money markets would almost certainly be the path through which European debt troubles would affect the U.S., but predicting how U.S. institutions would fare would be highly speculative: leverage and counterparty risk, not strict asset quality, would be the problem.
A case can be made that questions about Europe's sovereign debt are every bit as fundamental as the solvency concerns at stake in the 2008 crisis. Yet Deloitte's Saddique argues that American banks have done a better job preparing for any spillover.
Fears about peripheral countries, "as an issue, was there last year," he said, giving regulators and large banks plenty of time to consider their holdings and risks, something he believes they've done fairly well. The advantage of such prep time would distinguish any European crisis from 2008, he said, "when nobody quite understood the effects in the markets of Lehman going away immediately."
Miller and other observers say it's the recognition of how disastrous widespread counterparty fears would be that ensures governments would step in to prevent them from taking hold. While major U.S. institutions may be well hedged, the quality of that protection is dependent on the stability of other parties.
"Netting only works if there are counterparties – that's why they can't let anyone fail," he said. "I believe the big developed countries will do everything in their power to keep these banks afloat. If something blows up, they will ring-fence it as fast as possible."
Recent Standard & Poor's research takes a similar position, concluding that only countries with "undeveloped or unpredictable bank regulation and relatively weak political institutions" would ever stand down in the face of a crisis threatening numerous institutions.
Despite the U.S. government's repeated insistence that Dodd Frank has ended too big to fail, S&P notes, "The U.S. government indeed has a long track record of supporting its large and systemically important financial institutions despite its stated preference for not doing so."
Nothing about how the U.S. or European governments have handled the 2008 crisis would suggest otherwise, but some longtime observers of risk management question whether the premise that governments will be there when needed has been taken for granted. There is a circularity in arguing that a disastrous collapse is not possible because all stakeholders recognize that it would be disastrous, says Bill Haraf, California's commissioner of financial institutions, a member of the Financial Stability Oversight Council, and former public policy director for Citi.
"There's too much complacency in the investment community that the government, broadly speaking, will come to the rescue of large financial institutions in the event of a new problem," Haraf said.
Longbrake agrees. It's impossible to fully prepare for the sort of catastrophic conditions that a wave of sovereign defaults would engender, but there's always more that can be done, he says. Money market exposure in particular could be pared back, both by funds and SEC dictate.
"It's been my experience that people prepare very badly" for anything systemic, he says. "There's an assumption that it will never happen, that it's too low probability."