I’m surprised it has taken this long for Someone Serious to make the argument set forth in a new article by Simon Johnson at Bloomberg, which in short form says “You are dreaming if you think a European financial crisis stays in Europe.”
Johnson somewhat undercuts the urgency and importance of his article by working from the assumption that the eurozone dissolves back into its earlier configuration of one currency per nation. Economists and analysts have discussed other scenarios, such as a exit by Greece, which has the potential to precipitate contagion in Portugal, Spain, and Italy; an exit by Germany; a split into more economically homogeneous sub-groups (most likely north v. south). And Bloomberg refrains from putting the real sizzler in the headline: Johnson considers JP Morgan to be vulnerable and explains why.
No matter how you look at it, the most important step that needed to be taken to prevent the recurrence of a global financial crisis was to reduce the interconnectedness of the major players. That has not happened to any meaningful degree. There are efforts underway to move more activities to clearinghouses, but nothing is operational, and the industry is working hard to limit the scope of these plans. So despite all the brave talk about how much better capitalized the big banks are, they’ve beaten back, delayed, and weakened efforts to deal with the biggest source of risk.
Johnson flags one major risk: what happens if a country exits and by legislative fiat, redemoninates contracts entered into by its government, and say, by the banks it has chartered, from the euro to a new domestic currency? That question has gotten some attention with regards to Greek bonds, with experts focusing on how many bonds are governed by Greek law, where the government could redenominate them by fiat, versus those governed by UK law (note that Johnson finesses that issue by positing the dissolution of the eurozone, meaning the euro no longer exists). And with the restructurings of Greek debt leading to new, senior borrowings being put in place, the older Greek law bonds are subordinate and less of a source of bargaining leverage than they once were.
Nevertheless, there is a much more basic reason to be worried. If any country were to leave, it would redenominate the currency of deposits held in domestic banks. For any periphery country, the value of the new currency is presumed to be lower than that of the euro. So depositors lose.
This concern has led to deposit flight from Greek banks and slower-motion runs on other periphery country banks. If Greece were to exit, it isn’t hard to imagine an acceleration of deposit departure from banks in periphery countries. The ECB could step in, but Germany officials have repeatedly nixed the idea of deposit guarantees in the absence of a banking union, which is not something you put in place on a crisis timeframe.
Johnson focuses his worries on the biggest source of excessive connectedness, derivatives, and also debunks JP Morgan’s “fortress balance sheet” claim:
For example, in recently released highlights from its so-called living will, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. (All big banks must provide their regulators with a living will to show how they could be shut down in an orderly fashion if near default.)
JPMorgan’s total balance sheet is valued, under U.S. accounting standards, at about $2.3 trillion. But U.S. rules allow a more generous netting of derivatives — offsetting long with short positions between the same counterparties — than European banks are allowed. The problem is that the netting effect can be overstated because derivatives contracts often don’t offset each other precisely. Worse, when traders smell trouble at a bank that has taken on too much risk, they tend to close out their derivatives positions quickly, leaving supposedly netted contracts exposed.
People with experience regulating or analyzing financially distressed institutions greatly prefer to measure potential losses with the European approach, in which netting is allowed only when contracts expressly incorporate settlement on a net basis under all circumstances.
When one bank defaults and its derivatives counterpart does not, the failing bank must pay many contracts at once. The counterpart, however, wouldn’t provide a matching acceleration in its payments, which would be owed under the originally agreed schedule. This discrepancy could cause a “run” on a highly leveraged bank as counterparties attempt to close out positions with suspect banks while they can. The point is that the netting shown on a bank balance sheet can paper over this dynamic. And that means the JPMorgan living will vastly understates the potential danger.
According to my calculations with John Parsons, a senior lecturer at MIT and a derivatives expert, JPMorgan’s balance sheet using the European method isn’t $2.3 trillion but closer to $4 trillion. That would make it the largest bank in the world.
What are the odds that JPMorgan would lose no more than $50 billion on assets of $4 trillion, much of which is complex derivatives, in a euro-area breakup, an event that would easily be the biggest financial crisis in world history?
Note that the issue isn’t the magnitude of exposures to a single counterparty; one defaulting counterparty leaves supposedly netted positions suddenly not netted all across the banking industry. That leads to more defensive behavior, namely, cutting exposures (say by increasing haircuts or closing out positions) with the weakest players. That of course pushes them closer to the brink. In the worst of the crisis, banks weren’t able to repo Treasuries, that’s how extreme the fear of counterparty exposures had become. (For those who want to know more, Lisa Pollack provided a great primer on gross and net CDS exposures; it gives a simplified but useful example).
And the $2.3, or per Johnson and Parsons, $4 trillion of JP Morgan “balance sheet” exposures don’t tell the whole story. Banking expert Chris Whalen has described JP Morgan as a $2 trillion banks attached to a $75 trillion derivatives clearing operation. Why do you think, when Lehman and MF Global got wobbly, that JP Morgan became more and more difficult to deal with? Because their role as clearer made them particularly exposed.
Now you might say, “didn’t JP Morgan submit a preliminary plan for an orderly wind down? Surely we can manage this sort of thing now.” Don’t hold your breath. Top bankruptcy lawyer Harvey Miller objected to the decision to put Lehman into bankruptcy in haste, warning that the failure of a mid-sized broker/dealer (and Lehman was clearly bigger that) disrupted markets. JP Morgan’s outline assumes (and the FDIC has taken up this line) that in a worst case scenario, the authorities can wind down the holding company, wiping out equity holders and cramming down bondholders as needed, and keep the operating subs going. The problem is that neither the FDIC speech on this topic nor the JP Morgan presentation deal with derivatives, collateral, or repo. Derivatives contracts are not at the holding company level but are booked in the depositary. I’m told foreign counterparties would seek to terminate these agreements, and sources guesstimate that 30% to 50% of JP Morgan’s derivatives agreements are subject to UK law. Thus it is not hard to imagine that distress at the holding company will prove difficult to contain. In other words, there is likely to be a considerable difference between how the Orderly Liquidation Authority works in theory versus in practice.
Johnson’s warning is clear: a eurozone crisis is not likely to be contained, and the biggest US banks are exposed. And it is looking more and more likely that we’ll find out whether the regulators can, as they insist, manage a big bank failure without engaging in massive bailouts.