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Greece default - do not be so sure of yourself



November 14, 2011 – Comments (3)

Many Fool articles, along with articles from many other respected business sources, have opined that a default by Greece on their gov't bonds, ain't no big deal. They calculate the direct exposure of several large banks versus their tier 1 reserves, and conclude that they can handle a default of Greek bonds. Further, these journalists include a table of previous sovereign defaults, along with a tut-tut that these previous deals were not a big deal, one more will be no more imporant.

I beg to differ, big time. I bring to your attention 2 cases that, as noted above, should have had no big effect. Both cases brought the world's financial system to its knees in unanticipated ways.

Case Study #1 - Long Term Capital Management (LTCM)
This hedge fund found, so they thought, the holy grail of mathematical equations (Black-Scholes-Merdon) that guaranteed that they would make piles of cash. So they did: they were leveraged up to their eyeballls, controlled more than a $1trillion in assets, and counted among their customers well known and highly regarded banks.
Problem: the Russian gov't defaulted on their sovereign bonds. Well, so what? Here is what: all of their bets went against them. They were on the verge of insolvency and an international banking catastrophe. The Fed was obligated to step in with a rescue package. It was so huge, that, to this day, the size of said bailout has never been revealed.
Who woulda thunk that a problem with Russian bonds would trigger Armagedon?

Case Study #2 - LIBOR
The Fed, SecTreas, and friends, in the Fall of 2009, was about to let Lehman Bros (LEH) go insolvent. They thought that they had the entire event sown up solid, in particular the Credit Default Swaps, most of which were the responsibility of AIG. So, LEH was allowed to go belly-up. Overnight interbank lending, LIBOR, market got spooked and froze up solid for months.
Problem: this lending is the life blood of the international financial system. Without it, the patient could not breathe.
So, a rather trivial financial mechanism that no one except university professors had ever heard of, caused the Great Recession, and we are still suffering from it.

So, let these 2 cases be a warning. The so-called 'Black Swan' can emerge from events that you are sure were safe. Do not be so sure of yourself of your judgment. You could be terribly wrong. It is entirely possible, though maybe not very likely, that a Greek sovereign default could result in yet another 'Black Swan' from a rather tangential and seemingly trivial side effect. Do not say that I did not warn you.

3 Comments – Post Your Own

#1) On November 14, 2011 at 11:20 PM, constructive (99.97) wrote:

"It was so huge, that, to this day, the size of said bailout has never been revealed."

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#2) On November 14, 2011 at 11:50 PM, RallyCry (25.36) wrote:

Awesome write up. Couldn't agree more. 

My first takeaway from the LTCM wikipedia article is that a certain former governor was closely associated with LTCM and was forced out of Goldman by Henry Paulson after the crisis in 1998.

So to summarize, a guy takes on too much leverage on European sovereign debt and his firm crashes and burns some 13 years after he was closely associated with a firm that took on too much leverage on Russian bonds and collapsed. This isn't a management or internal control problem, the guy was convinced Europe was going to be bailed out out just like LTCM. Or he thought he could open such a large position that his company would be bailed out. This way he can't lose. 

The problem is Europe may need approximately 1-3 trillion in bailouts, where the 3 billion LTCM received is a drop in the ocean compared to Europe's debt problems. The Greek write off triggered MF's fall. Another problem was company wasn't considered too big to fail so he was shut down...Hopefully this isn't black swan #3.

The second takeaway from the wikipedia article on LTCM is that Lehman doled out up 100 million toward the LTCM bailout yet was allowed to fail because they were not too big too fail as many saw it. It was nice to see the government remembered Lehman's participation in LTCM's rescue while Bear Stears who refused to participate was bailed out shortly after Lehman failed. Inequality doesn't just exist among people, it exists among wall st. firms. When will the 99% of businesses start marching?

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#3) On November 15, 2011 at 12:32 AM, constructive (99.97) wrote: 

Lehman failed because no one was willing to buy them outside of bankruptcy, and the Fed's negotiations ran out of time. 

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