Are U.S. Banks Going Out on a Limb Again?

Are U.S. Banks Going Out on a Limb Again?

You think we’d have learned. Back in the financial crisis of 2008, our banking system got into trouble because it took on too much risk. Stupid risk. Disproportionate risk.

Are they doing it to us again?

If you hold Greek or Italian debt, you’re probably concerned that those countries might default and you’d never get your money back. (Here’s what’s going on in Greece.) To protect yourself, you might buy “insurance” from a bank like JPMorgan Chase that would pay out if your investment in Greek or Italian bonds went bust.

This kind of insurance actually exists. In the face of the European debt crisis, U.S. banks have been increasing their sales of insurance against credit losses.

Sounds Good …  But It’s Not

Insurance against losses might sound like a great boon to investors, but what about the banks underwriting the insurance? As it is, many banks already own lots of debt in troubled European countries like Greece, Portugal, Ireland, Spain and Italy. By underwriting “insurance” on these loans, they’ll suffer doubly if these countries default—because they’ll have losses in their own holdings and have to pay out the investors who bought insurance.

As we’ve said in the past, one of the big fears surrounding the crisis in Europe is that one big default could cause a domino effect among the countries and institutions that hold its debt.

“Hedging” an Investment

You’ve probably heard the phrase in regular speech: “I’m hedging my bets.” In a financial context, that means reducing the risk that you’ll suffer if an investment you made goes south. Usually, this takes the form of investing in something else that offsets the investment you already made.

For example, say you invested in Apple, which is a bet that its share price will go up and up. But, what if something unforeseeable happened to bomb the whole tech industry?

To prevent a huge loss from your Apple stock, you might simultaneously bet against Microsoft (called “shorting” a stock). So, if the market held up and Apple earned profits, you’d make money from that. But if the whole tech sector went bust, your bet against Microsoft would make you some money to offset your losses from Apple.

Now, we’re not saying to go around shorting stocks (for various reasons, doing so is very risky in its own right). But the same general principle applies to what’s happening with European debt.

Your Economic Cheat Sheet

Want to know what's happening on Wall Street—and beyond? Sign up for The Market, LearnVest's new weekly newsletter
SIGN UP HERE 

What’s Going On Now

When investors buy European debt, they’re basically betting those countries won’t default and they’ll get their money back. Buying insurance against those positions is hedging; investors pay a bit upfront (by buying insurance) to offset potential losses if their European investments go bust. For investors, this is probably pretty smart.

But as things in Europe have become ever-dicier, U.S. banks have been selling more and more insurance, which has increased U.S. banks’ risk in troubled European countries by 20% within six months. For example, as the dire situation in Italy came to the foreground this week, sales of insurance against Italian debt, sold by U.S. banks, surged. (Here’s more on what’s happening in Italy.)

What Goes Around Swirls Around

This is reminiscent of the issues multinational insurance corporation AIG had back in 2008. Back then, banks tried to hedge their risky investments by buying a ton of insurance from AIG, which sold more than it could handle. When push came to shove and those investments went bad, AIG ran out of cash to pay back all of the collateral. In the end, the U.S. government took over the company to prevent it from collapsing, because a collapse would’ve meant tens of billions of dollars in losses for other banks.

And this wasn’t just AIG; around that time, banks made a habit of taking on risky investments and selling insurance against those investments—exposing them to a huge amount of risk. To offset that risk, they’d buy insurance from other financial institutions to hedge their investments. But those other financial institutions were offsetting their own risk with insurance from other institutions, and so on. Around and around in a big circle of risk-sharing.

In the end, someone’s got to be responsible for the final losses. If you buy your insurance from a company that can’t back it up, what good is it?

Learnvest

Financial planning made simple.

Get your free financial assessment.

Related Tags

Get the latest in your inbox.

Subscription failed!

You're Now Subscribed!