Will the Tide Run Out on Goldman Sachs and JP Morgan?

Warren Buffett famously said, “It’s only when the tide runs out that you find out who’s been swimming naked.”

Could this apply to the massive credit derivatives positions carried by U.S. investment banks such as JP Morgan (NYSE:JPM) and Goldman Sachs (NYSE:GS)? A lot of these positions hinge on debts floated by Eurozone countries such as Greece, Italy (NYSE:EWI), Ireland, Portugal, and Spain (NYSE:EWP).

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Unfortunately for shareholders, the banks’ accounts reflect only the ‘net’ position and not the full picture of likely losses or gains in the event of a sovereign default. An exception is Jefferies (NYSE:JEF), which disclosed each long/short position on its books that related to European debt.

The precarious position for shareholders was explained this way by Lloyd C Blankfein, Goldman Sachs (NYSE:GS) CEO and Chairman, at a meeting with Financial Crisis Inquiry Commission last year: “We either have netting agreements, or they foot, or they cancel each other out, or they’re longs and shorts on the same instrument,” he said, answering a question about how the firm manages so many contracts in a crisis. “The only way you can run a business like that is to have these systems work so they can aggregate stuff, so you can run the business on a macro basis, and also so you can get the details quickly if you need them. And that’s all systems and technology.”

In accordance with Financial Accounting Standards Board directives, as of Sept. 30, JPMorgan (NYSE:JPM) said it had sold $3.13 trillion of credit-derivative protection and purchased $3.07 trillion, up from $2.75 trillion sold and $2.72 trillion bought at the end of 2010. Goldman Sachs (NYSE:GS) disclosed it had written $2.07 trillion and bought $2.20 trillion, about the same amount it reported at year-end. According to the Bank for International Settlements, guarantees provided by U.S. lenders on government, bank and corporate debt in Greece, Italy, Ireland, Portugal and Spain rose by $80.7 billion to $518 billion in the first half of 2011.

Another grey area is counter-party risk. “Their position is you don’t need to know the risks, which is why they’re giving you net numbers,” said Nomi Prins, a former managing director at New York-based Goldman. “Net is only as good as the counterparties on each side of the net — that’s why it’s misleading in a fluid, dynamic market.”

Unfortunately, like we saw when Lehman imploded, a failure somewhere, by some unexpected party can lead to a chain reaction. Then, when the tide runs out, there is no knowing how much red would wash up on banks’ balance sheets.