America's 'too big to fail' moment

The US is in no danger of long-term default, but like Lehman it could trigger a dangerous derivatives squeeze. And European banks are more exposed to government bonds than ever before.

Australia will not escape serious flow-on effects if the US defaults on its government debt. Not only will global interest rates rise but a US default will have severe effects on the international derivatives market, where we are a significant player.

And, as I explain below, a prolonged US crisis could be the trigger that sends the European banking system into a downward spiral.

World share and debt markets remain confident there will be a US deal on its debt crisis before Thursday, American time, and they are probably right – the US is 'too big to fail'.

But no one will forget September 2008, when up to 10 days before the Lehman bankruptcy, Lehman bonds were trading about 95 cents in the dollar, which was in line with its peers. Lehman was 'too big to fail', or so the market thought.

The reason the Lehman failure was so catastrophic was its effect on the derivatives market – the $200 trillion unregulated market that connects the world’s banks. In the case of Lehman an immediate consequence was the freezing of the repurchase agreement, or ‘repo’, market.

If any US debt default extended longer than a short period (no one is certain whether a ‘short period’ should be defined as a few hours or a few days), exactly the same thing will happen only on a much bigger scale.

Banks and investment houses use the ‘repo’ market for secured, short-term borrowing. Between $2.5 trillion and $3 trillion worth of US Treasury bonds are used as collateral for ‘repo’ loans. When Lehman banks and investment houses found that the collateral they believed was backing their loans was no longer there, the market froze and the ramifications spread through the global banking system via derivatives. A huge credit squeeze with much higher interest rates followed.

If global rates rise this time it will be Europe that will quickly become very vulnerable because of the inevitable fall in European bond prices.

The Financial Times reported at the weekend that Europe’s financial institutions are more exposed to their domestic government bonds than at any time since the eurozone crisis started.

Government bonds accounted for more than a tenth of Italian banks’ total assets at the end of August, compared to 6.8 per cent at the beginning of 2012.

In Spain, the proportion has risen from 6.3 per cent  to 9.5 per cent over the same period, and in Portugal it has increased from 4.6 per cent  to 7.6 per cent.

By far the majority of the increases are in holdings of bonds issued by the banks’ own governments – this breaks all the rules of sound banking and is simply a 'too big to fail' strategy.

The world banking scene is very vulnerable to a European crisis and therefore doubly vulnerable to events in the US.

However, we should not forget that the US is not Lehman and, even if there is a crisis, payment will take place in time – which is why for a short period markets will manage. However there is a twist to this part of the tale. One of the reasons why no agreement has been reached in Washington is that the markets have not panicked. There is a real prospect that there will be no agreement until the markets start to crumble and either force both sides to make concessions or one side to retreat.

A week ago I made similar remarks (Showdown at the Senate saloon, October 7). So far I am right but there are no certainties in this game. Although cooler heads are now running the negotiation, I fear that the global markets may have underestimated the determination of Ted Cruz, who is the first Hispanic elected a US senator. Cruz is leading the Republican fight to gain spending cuts from President Obama.

Cruz believes with a passion that history is on his side in this campaign. He points out that since 1978 Congress has raised the debt ceiling 55 times and in 28 of those actions Congress has attached stringent spending requirements.

On the 56th debt ceiling encounter the first Hispanic to become a Senator faces the first black President. Both men are still showing the steely determination that comes from their tough fight to the top.