In my last post I highlighted why Greece is so important to global markets and the global economy. I mentioned why contagion, especially in the financial markets, is so dangerous. In a recent article, Ed Harrison does a good job of explaining the ripple effect of the Greek default. Below I try to summarize the general idea:
European banks own Greek debt. To insure this debt they purchase a CDS contract. In this contract banks (i.e. the buyer) pay the writer of the contract every year. The writer of the contract promises to pay the buyer the face value of the contract in the event of default. A CDS is essentially insurance on the Greek bonds.
Thus, if Greece defaults the writers of these contracts will have to pay out. These contracts may have been written by US financial institutions. Therefore, a default by Greece could trigger large cash payments from US institutions, putting them at risk.
These payments may or may not be manageable. A greater issue would probably be if Ireland or Portugal or a larger European country is forced to default as credit markets cease up. This would in turn force US institutions to pay out CDS contracts on those countries debt instruments.
Going even further, a default in Greece could put European financial institutions at risk even with CDS contracts insuring the debt. If those banks take large hits to their balance sheets or even fail, any US financial institutions with direct exposure (e.g. loans) or who wrote CDS contracts would be under pressure.
Essentially, the above excerpt illustrates how global financial markets have become interconnected and interdependent upon one another. How exposed is the US to European sovereign bonds and bank debt? I don’t believe anyone is quite sure, especially given the lack of transparency in the CDS market.
The point of concern is that one relatively small event can cause a systemic disruption across global financial markets given how interconnected and opaque they are. This is why the prospect of a Greek default is negatively impacting our markets.
