U.S. Investment Banks Overexposed to Possible European Defaults?

U.S. banks J. P. Morgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Morgan Stanley (NYSE:MS) have a collective exposure of over $80 billion to the PIIGS countries, i.e. Portugal, Italy (NYSE:EWI), Ireland, Greece and Spain (NYSE:EWP). However, these banks have reportedly covered themselves against possible default on this exposure by taking out insurance in the form of credit default swaps (CDS) – but this covers only about $30 billion leaving their exposure at still a high $50 billion.

However, there could be doubts about payments on this insurance materializing in the event of a systemic and global financial crisis. Mark Spitznagel, chief investment officer at Universa Investments, a hedge fund, said through a spokesman, β€œthe likelihood of actually getting paid out from owning a credit default swap would be troubling to me if this were my hedge against a systemic shock β€” especially in a political environment unfriendly to more Wall Street bailouts.”

Efforts to assess the actual risk faced by these U.S. banks (NYSEARCA:KBE) are stymied by differences in disclosure practices and opaque accounting treatment. This could change with the SEC now insisting on full and consistent presentation of European positions. It would also expose the dependability of CDS where these have been bought from European banks, and which might not be in a position to pay out. A longstanding demand to centrally clear CDS may now have to be implemented, though it may result in the CDS premiums rising.