June 20, 2011

The US Fed Will Have Its Hands Full, Again


"When they meet Tuesday and Wednesday, Fed officials will likely discuss what they might do to help shield U.S. banks and a still fragile U.S. economy if Europe's crisis worsened. Some analysts suggest that a panic would cause the Fed to intervene as it did during the 2008 financial crisis, when it lent billions to banks.
"The European debt crisis has the potential to have as big an impact as the subprime mortgage crisis did in the United States," said Sung Won Sohn, an economics professor at California State University. "If it spreads to Spain and Italy, then the global economy could be facing huge problems.""

It begins, this time, with Greece. A Greek default will trigger holders of Greek sovereign debt (their bonds) to cash in the hedging investments they made as "insurance" against such a default. That "insurance," called a Credit Default Swap (CDS), is an investment instrument sold to bondholders by large investment banks an insurers to protect the bondholders against loss.

Sound familiar? Bear Sterns sold a lot of CDS products against mortgage-backed securities pre-2007. So did Lehman Brothers. Bear sold for pennies on the dollar just before they became insolvent. Lehman was allowed to fail, and the credit crisis of 2008-2009 was the result. The US economy fell into recession at about the same time.

Germany and France are major holders of Greek debt. Guess where they bought their hedging CDS instruments?