The $616 billion question: Does the euro crisis have a hidden AIG?

It's the $616 billion question: Does the euro crisis have a hidden AIG? 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 US 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 non-bank entities like insurance companies and hedge funds.

Asked about derivatives tied to Europe at a Wednesday press conference , Ben S Bernanke , the chairman of the Federal Reserve, said that the direct exposure is small but that "a disorderly default in one of those countries would no doubt roil financial markets globally. It would have a big impact on credit spreads, on stock prices and so on.

And so in that respect I think the effects in the United States would be quite significant." 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 per cent 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.

Source:http://economictimes.indiatimes.com

Neeraj Rajgarhia
Summer Intern - Technical Analyst
DENIP Consultants Pvt. Ltd.