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Edward Harrison: Here's what happens if Italy defaults—an "Armageddon scenario"

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I alluded earlier to this piece by Edward Harrison in the great Naked Capitalism. In my earlier post, I wanted to bottom-line it and tack on Krugman's agreement. (See here for that bottom line.)

Now I'd like to dig into some of its details. Harrison starts with a couple of background premises:

■ The world is in a "cyclical uptick within a larger depression." (Ugh.)

■ For countries with a "lender of last resort" (countries that can borrow from their own central bank), the depression will be "soft" — we can talk about what that means later.

■ Italy has no lender of last resort. Unless Italy's bonds are backstopped by the European Central Bank (ECB), it can't afford to finance its debt — current market rates on Italian bonds are just too high for Italy to issue them at competitive prices.

This creates an "Armageddon scenario" for Italy, and a need for investors to learn how to protect themselves. The rest of this post outlines Harrison's Armageddon scenario — what happens if — or when — Italy defaults.

(Note: There is much more detail in the article; these are just the short strokes.)

1. A "credit event":

[A]n Italian default would be uncontrolled and immediately crystallise losses that must run through the balance sheets of everyone holding their bonds.
This is why no one in the market wants to buy Italian bonds right now, why the interest rate is so high relative to German bonds. That 2% higher rate is the "risk premium" and it's going through the roof.

2. A bank run:
Once Italy defaults, Italian banks would be insolvent as a result of these losses since they are the largest holders of Italian sovereign debt.
3. Increased pressure on weaker economies with similar bond pricing problems. Named countries include Slovenia, Spain, Austria and Belgium (yes, Belgium). Also Ireland, Portugal and Greece. The contagion could then spread to Eastern Europe — the Ukraine, Kazakhstan and the like. That's a huge and important list, a real house of cards.

Harrison offers a fascinating and careful analysis. Remember, it's all based on willingness of investors to buy the bonds of these countries. As 10-year rates rise to 6%, 7% and higher, self-financing becomes more and more impossible.

For comparison, the coupon on U.S. 10-year bonds is 2%. The U.S. borrows for free.

4. Threat of bank insolvency in the Euro core. Here's a chart showing core bank holdings of European peripheral sovereign debt. Click to big, then look at the Italy stack. The Y-axis shows millions.

Subtract out the Italian banks, and look at the rest. If I read the chart right, it looks, for example, like Société Général is holding just under €10 billion in Italian debt alone. (That euros, not dollars.) Many other banks are exposed.

Total Italian debt held by all core EU banks is €100 billion. Add about €40 billion for the debt of the other four countries listed. That total is the exposure of core Euro banks to the sovereign debt of just five vulnerable economies.

France, Germany et al, could make their own banks whole again, but will they? And if so, how? (Remember, in Europe at least, the voters get to choose their candidates. What will those candidates do?)

5. Credit default swaps — bets on the default of the peripheral nations — get triggered worldwide. This could actually be the big enchilada (in my opinion). A bond can default only once. But the number of bets on that default can be limitless (in the absence of ... ahem ... regulation). Harrison:
As an Italian default would be a credit event, it would trigger credit default swaps, many of which were sold by American financial institutions. Would these institutions pay out? Could they?
CDSs have already taken down MF Global and Jon Corzine (who needs to be reminded there are jail cells). Just recently there is news that U.S. banks may be on the "AIG side" of those CDS bets.

From Bloomberg (my emphasis, h/t Matt Stoller):
JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS), among the world’s biggest traders of credit derivatives, disclosed to shareholders that they have sold protection on more than $5 trillion of debt globally.

Just don’t ask them how much of that was issued by Greece, Italy, Ireland, Portugal and Spain, known as the GIIPS.
When you "sell" protection, you promise to make the counterparty whole in the case of a default. JPM and GS won't say whether they were on the sell side, kind of a clue they were.

If they are exposed, can you say "second bank bailout"? Good. Now form the words: "President Mitt Romney" and "Hello to the New 1930s."

That just touches the surface of Harrison's analysis. Again, please read to learn more.

This is so off the radar of most Americans, and shouldn't be. Offered as my small (if not short) contribution to your understanding.

(Roman ruins photo via Shutterstock)


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