I have been writing this week about three news stories that point towards major changes in our financial system. These include massive resignations of financial leaders and the seizure of large denomination United States Treasury Bonds. Today, I focus on the third story, the financial situation in Greece.
At first glance, it seems that Greece’s situation is not that big a deal. Even though its capital, Athens, is called the birthplace of democracy, Greece has lost its position of importance in the 21st Century. Fewer people live there than live on Manhattan Island. It has the world’s 37th largest economy. Those aren’t exactly head-turning numbers.
The purpose of this article is to explain how we got to this point.
To do this, we need to go back to a previous story on Peace of Mind News. It is the bankruptcy of MF Global, a major global financial derivatives broker. Derivatives were labeled by Warren Buffet as “weapons of financial mass destruction.” They are bets placed on risky financial instruments with huge odds. They create massive profits for banks in an expanding market.
Another way to see derivatives is as insurance purchased against investments that go bad. The premiums on this insurance produce the profits.
These profits are made at great risks. When the market contracts even a little bit, the derivatives, which are so highly leveraged that there isn’t enough money in the world to cover them, become losers and must pay. If they can’t pay, this creates significant problems.
This is what happened in 2008 when banks had to be bailed out by The Fed. The markets contracted and the banks were contractually obligated to pay out on the derivatives. They didn’t have the money to do so and used the “too big to fail” argument to squeeze taxpayer money because that was “best for the country.”
The subsequent regulations now give the banks control over whether or not they pay on their derivatives. It is like giving auto insurance companies unilateral power to say how badly a car must be damaged in an accident before they have to pay.
MF Global became a victim of this situation. They were speculating on European bonds and, according to conservative figures, were leveraged at 40 to 1. This means that they could not withstand a three percent downturn in the market. (Do the math – divide 1 by 40 and you get 2.5.)
They thought they were risk-free on this because they had purchased derivatives (insurance) for these investments.
When last fall’s Greek credit event cut the value of MF Global’s investments by fifty percent, they filed an “insurance claim” for the default. The banks said the credit event wasn’t officially a default since Greece paid half the amount due. Therefore, they didn’t honor the claim.
This is like a bank accepting fifty percent of your mortgage payment each month and not declaring you in default. It is comparable to an auto insurance company saying it doesn’t have to pay a claim because the car was only half destroyed in the accident.
MF Global was toast and its clients’ money was gone in a puff of smoke.
This brings us to the present and an amazingly tenuous situation that threatens to take down JPMorgan Chase, Citigroup, Bank of America, HSBC, and Goldman Sachs.
I’ll describe the details tomorrow.