By Patrick A. Heller
Commentary on Precious Metals Prepared for CoinWeek.com
In my last column I warned readers that the default of Greek sovereign debt can happen much sooner than the politicians admit. If (I really mean “when”) this crisis hits, what is likely to occur will almost certainly result in the bankruptcy of major US banks. Here’s how.
When the Greek sovereign debt defaults, I fully expect the US Treasury and Federal Reserve to do everything possible to shore up global finances. I’m sure this would include a combination of publicly disclosed tactics meant to reassure the public and also behind the scenes moves that would scare people if they became widely known. In this process, it would not surprise me to see the US government spend hundreds of billions to trillions of dollars.
Unfortunately, the US government simply does not have enough resources to manage every problem.
For instance, credit default swaps (CDS) are currently a $32 trillion market. That is double the size of the US Gross Domestic Product. It is also about double the size of the “official” national debt.
Credit default swaps are a derivative taken out by investors as insurance against defaults in the repayment of loans. According to the US Comptroller of the Currency, nearly 95% of the banking industry’s exposure to derivatives contracts is held by five of the largest US banks: JPMorgan Chase, Citigroup, Bank of America, HSBC, and Goldman Sachs.
Credit default swaps are unregulated. There is no requirement that the sellers of these derivatives have the financial ability to pay to cover losses on debt defaults. But, the risks are even worse than these two loopholes.
Whether a failure of a debtor to make a required payment constitutes a default requiring a payment on a credit default swap is determined by the International Swaps and Derivatives Association (ISDA). Guess what, the ISDA is owned by the world’s largest banks and hedge funds. That means that the banks that would be required to make payments on credit default swaps are also the institutions that decide whether payments are required.
The MF Global bankruptcy last October was triggered by credit default swap losses. MF Global was a major derivatives broker, leveraging its exposure at least 40 to 1. Because of the extreme leverage, the derivative losses on $6.3 billion of some shaky European debt pushed the company into bankruptcy.
In theory, MF Global owned credit default swaps which should have covered the losses. But the ISDA declared that the decline of European debt, as much as 50% of face value in some circumstances, was not a default. Therefore, the MF Global’s counterparties on the credit default swaps did not have to pay up, guaranteeing the failure of the company.
The failure to collect on credit default swaps in the MF Global bankruptcy has shaken confidence in the entire market for derivatives. In other words, when investors see that MF Global was unable to collect on their credit default swaps, they will tend to refuse to purchase such derivatives. Although the five major US banks don’t want to admit it, a major percentage of their recent operating profits have come from the sales of derivatives such as credit default swaps. If these banks don’t pay up for their liability in the default on Greek sovereign debt, they will lose billions of dollars in future profits.
It is not surprising that mega-billionaire investor Warren Buffett declared derivatives to be “weapons of financial mass destruction.”
Even if the US government could print enough Federal Reserve Notes and issue enough Treasury debt to prevent the failure of these five banks, the result of this hyperinflation of the money supply would destroy the US dollar.
Although the immediate financial system looks set to collapse, that is not necessarily all bad news. That would be a great opportunity to re-introduce a stable monetary system that politicians could not manipulate—such as physical gold and silver.
Patrick A. Heller owns Liberty Coin Service and Premier Coins & Collectibles in Lansing, Michigan and writes Liberty’s Outlook, a monthly newsletter on rare coins and precious metals subjects. Past newsletter issues can be viewed at http://www.libertycoinservice.com. Other commentaries are available at Numismaster (http://www.numismaster.com under “News & Articles). His award-winning radio show “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 AM Wednesday and Friday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio and text archives posted at http://www.1320wils.com.