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Simon Johnson: Enormous Risk on Economic Horizon

Posted by Larry Doyle on June 25, 2012 7:56 AM |

What is my risk?

In the throes of evaluating any and all proposals or investment opportunities,  I always want to understand where the risks lie and just how great those risks may be. From there, I try to evaluate if the projected return on invested capital is attractive relative to the risks undertaken.

What are the risks investors face? Interest rate risk, credit (i.e default) risk, volatility risk, structure risk, counterparty credit risk, prepayment risk, general market risk, liquidity risk, extension risk, transparency risk, political risk, and currency risk. Well, if that were not enough to consider, there is another very real risk lurking on our economic horizon.  What might that be? 

Dissolution risk. As if investors did not have enough on their plate already. What does dissolution entail?

the undoing or breaking of a bond, tie, union, partnership, etc.; the breaking up of an assembly or organization; dismissal; dispersal.

We do not need to think too hard to appreciate that there is very real dissolution risk lurking across the pond right now. What does this all mean and why should everyday investors be concerned?

Highly regarded economist Simon Johnson sheds further light on this new enormous risk in writing at Bloomberg:

Even the optimists now say openly that Europe will only solve its problems when the alternatives look sufficiently bleak and time has run out. Less optimistic people increasingly think that the euro area will break up because all the proposed solutions are pie-in-the-sky.

If the latter view is right — or even if concern about dissolution grows in coming months — markets, investors, regulators and governments need to worry not just about interest-rate risk and credit risk, but also dissolution risk.

What’s more, they also need to worry a great deal about what the repricing of risk will do to the world’s thinly capitalized and highly leveraged megabanks. Officials, unfortunately, appear not to have thought about this at all; the Group of 20 meeting and communique last week exuded complacency and neglect.

Very few people seem to have gotten their heads around dissolution risk. Here’s what it means: If you have a contract that requires you to be paid in euros and the euro no longer exists, what you will receive is unclear.

Whether you have direct or indirect exposure to an institution facing very real dissolution risk, we are all impacted by this risk. How so?

Financial institutions will need to build sufficient capital buffers to withstand potential losses from dissolution risk. We have been told that American banks have sufficient capital, so we have little to worry about, correct?

Are you hesitating there for a second wondering if we are supposed to blindly believe the bankers and regulators on this topic? In a world of “too big to fail” banks, do you think those banks just might discount the potential fallout of dissolution risk? I do. What does Johnson think? Let’s navigate.

Personally, I’m most worried about the balance sheets of the really big banks. For example, in recently released highlights from its so-called living will, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. (All big banks must provide their regulators with a living will to show how they could be shut down in an orderly fashion if near default.)

JPMorgan’s total balance sheet is valued, under U.S. accounting standards, at about $2.3 trillion. But U.S. rules allow a more generous netting of derivatives — offsetting long with short positions between the same counterparties — than European banks are allowed. The problem is that the netting effect can be overstated because derivatives contracts often don’t offset each other precisely. Worse, when traders smell trouble at a bank that has taken on too much risk, they tend to close out their derivatives positions quickly, leaving supposedly netted contracts exposed.

People with experience regulating or analyzing financially distressed institutions greatly prefer to measure potential losses with the European approach, in which netting is allowed only when contracts expressly incorporate settlement on a net basis under all circumstances.

When one bank defaults and its derivatives counterpart does not, the failing bank must pay many contracts at once. The counterpart, however, wouldn’t provide a matching acceleration in its payments, which would be owed under the originally agreed schedule.

This discrepancy could cause a “run” on a highly leveraged bank as counterparties attempt to close out positions with suspect banks while they can. The point is that the netting shown on a bank balance sheet can paper over this dynamic. And that means the JPMorgan living will vastly understates the potential danger.

According to my calculations with John Parsons, a senior lecturer at MIT and a derivatives expert, JPMorgan’s balance sheet using the European method isn’t $2.3 trillion but closer to $4 trillion. That would make it the largest bank in the world.

What are the odds that JPMorgan would lose no more than $50 billion on assets of $4 trillion, much of which is complex derivatives, in a euro-area breakup, an event that would easily be the biggest financial crisis in world history?

A few officials see the storm coming. The Swiss National Bank should be commended for putting renewed pressure on Credit Suisse to increase its capital levels by suspending dividends. The Bank of England has set up emergency liquidity facilities, and continues to press for more bank capital, although it could do more.

The Federal Reserve should apply the same approach to big U.S. banks, with an emergency and across-the-board suspension of dividend payments, but it won’t. The Fed is convinced that its recent stress tests show U.S. banks have enough capital even though these tests didn’t model serious euro dissolution risk and the effect on global derivatives markets.

Starting to understand why the road we travel on our economic landscape is so long and steep? Whether dissolution happens or not, institutions and investors need to prepare for the chance that it may. Why do you think so many banks were recently downgraded? This risk preparation in terms of increased capital buffers comes with a very real price. The buffers disallow the use of the capital for other growth opportunities.

A persistently slower overall economy is the resulting reality in which we currently live and operate. Not that our politicos and financial analysts would want to share this with you. What a tangled web in which we live, work, and invest. For those who care to review all of Johnson’s thoughts, read U.S. Banks Aren’t Nearly Ready for Coming European Crisis.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

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