Contracts Cloud Who Has Exposure in Greek Crisis

No one seems to be sure, in large part because the world of derivatives is so murky, but the possibility that some company out there may have insured billions of dollars of European debt has added a new wrinkle to the sovereign default debate.

In years past, when financial crises in Argentina and Russia left those countries unable to make good on their government debts, they simply defaulted. But this time around, swaps and other sorts of contracts have become so common and so intertwined in the financial markets that there are fears among regulators and financial players about how a Greek default would play out among derivatives holders.

The looming question is whether these contracts — which insure against possibilities like a Greek default — are concentrated in the hands of a few companies, and if these companies will be able to pay out billions of dollars to cover losses during a default. If there were a single company standing behind many of these contracts, that company would be akin to the American International Group of the euro crisis. The American insurer needed a $182 billion federal bailout during the financial crisis because it had insured the performance of mortgage bonds through derivatives and couldn’t pay on all of them.

Even regulators seem unsure of whether a Greek default would reveal such concentrated risk in the hands of just a few companies. Spokeswomen for the central banks of both Europe and the United States would not say whether their researchers had studied holdings of such contracts among nonbank entities like insurance companies and hedge funds — and they would not say what would occur among large players if Greece or another European country defaulted.

Derivatives traders and analysts are debating just how much money is involved in these derivatives and what sort of threat they pose to markets in Europe and the United States. On the one hand, just over $5 billion is tied up in credit-default swap contracts that will pay out if Greece defaults, according to Markit, a financial data firm based in London. That’s less than 1 percent the size of Greece’s economy, but that is a conservative calculation that counts protections banks have in place offsetting their positions, and is called the net exposure. The less conservative figure, the gross exposure, is $78.7 billion for Greece, according to Markit. And there are many other types of contracts, like about $44 billion in other guarantees tied to Greece, according to the Bank of International Settlements.

The gross exposure of the five most financially pressed European Union countries — Portugal, Italy, Ireland, Greece and Spain — is about $616 billion. And the broader figure on all derivatives from those countries is unknown.

The pervasiveness of these opaque contracts has complicated negotiations for European officials, and it underscores calls for more transparency in the derivatives market.

The uncertainty, financial analysts say, has led European officials to push for a “voluntary” bond financing solution that may sidestep a default, rather than the forced deals of other eras. “There’s not any clarity here because people don’t know,” said Christopher Whalen, editor of The Institutional Risk Analyst. “This is why the Europeans came up with this ridiculous deal, because they don’t know what’s out there. They are afraid of a default. The industry is still refusing to provide the disclosure needed to understand this. They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”

Regulators are aware of this problem. Financial reform packages on both sides of the Atlantic mandated many changes to the derivatives market, and regulators around the globe are drafting new rules for these contracts that are meant to add transparency as well as security. But they are far from finished and could take years to put into effect.

Darrell Duffie, a professor who has studied derivatives at the Graduate School of Business at Stanford University, said that he was concerned that regulators may not have adequately studied what contagion might occur among swaps holders, in the case of a Greek default.

Regulators, he said, “have access to everything they need to have. Whether they’ve collected all the information and analyzed it is different question. I worry because many of those leaders have said there’s no way we’re going to let Greece default. Does that mean they haven’t had conversations about what happens if Greece defaults? Is their commitment so severe that they haven’t had real discussions about it in the backrooms?”

Regulators aren’t saying much. When asked what data the Federal Reserve had collected on American financial companies and their swaps tied to European debt, Barbara Hagenbaugh, a spokeswoman, referred to a speech made by the Federal Reserve chairman, Ben S. Bernanke, in May in which he did not mention derivatives tied to Greece. And she said in a statement that the Fed had researched the “full range of exposures” at the companies it supervises — the banks — and is “monitoring the situation more broadly.”

At the European Central Bank, Eszter Miltenyi, a spokeswoman, said : “This is much too sensitive I think for us to have a conversation on this.”

On Wall Street, traders are debating whether the industry’s process for unwinding credit-default swaps would run smoothly if Greece defaulted. The process is tightly controlled by a small group of bankers who meet in an industry group called the International Swaps and Derivatives Association. .

The process is fairly well developed, but it has been little tested on the debt of countries. For the most part, Wall Street has cashed in on credit-default swaps tied to corporations’ debt.

Only one country has defaulted on its debt in the last few years — Ecuador at the end of 2009 — and its debt was so small and its economy so isolated that it was hardly a notable event.

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