10/26/2011 10:31 am ET | Updated Jan 09, 2012

Euro Crisis Serious Business For US Economy

Anybody imagining the Euro crisis won't affect this country should stop kidding themselves.

As Peter S. Goodman said last week, there's a real danger the entire Eurozone idea -- a currency without a nation state to manage it -- could soon collapse.

Since Goodman wrote that, European negotiations have fallen into an orgy of finger-pointing and nationalistic, beggar-thy-neighbor economic policies -- a scenario other well-informed observers have been predicting for some time, and pushed by a Germany still terrified by its memories of the Weimar Republic and what followed it.

If, as seems likely, it all falls apart, the collapse will take with it a noble and high-minded experiment, based on the idea that people can solve their problems together and create a better world. If that does happen, I think it may even set back globalization for a generation. And to my mind, a collapse is getting closer every day.

The Fed said as much last week, when it let Bank of America's Merrill Lynch subsidiary transfer an unspecified amount of its $75 trillion derivatives portfolio from the investment bank to the main, FDIC-insured bank, giving said derivatives an implicit FDIC guarantee. The Fed okay came after some Merrill counterparties in the deals asked for it -- parties who were obviously afraid they wouldn't get paid in a default.

The clear implication? These assets are at risk of losses from some Eurozone disruption. In sum, this was like a general who shifts troops to where he expects the main attack.

Which part of Merrill's derivatives holdings was shifted to the FDIC-insured bank wasn't disclosed and isn't publicly known. But my money is on the Eurozone-linked credit default swaps and the Euro-based cross-currency swaps, which have the highest probability of blowing up under pressure.

How much was probably dumped on the FDIC? The Office of the Comptroller of the Currency, which audits the national banks, says that taken together, the total money at risk for BofA here in the second quarter of 2011 was about $5.7 trillion -- almost four times BofA's total assets of $1.45 trillion. The new amount will obviously be larger.

In the second quarter, the two portfolios included $4.8 trillion in various currency swaps, while the rest of the risk was in its credit default swaps. That last amount was accounted for in what's called the gross positive fair value. The amount of either sort of contracts connected to the Euro isn't known, because the OCC doesn't require banks report it.

As bad as it is for taxpayers for the Fed to guarantee these deals -- over the FDIC's objections -- the real problem isn't that the FDIC is on the hook for any possible losses. This, even though the amount at risk is enormously higher than the $23 billion in losses it covered in all of 2010. If the Fed could find $16 trillion to shore up the financial system in 2008, it can do the like again, and even tell us about it, without the sky falling.

No. The real problem is that when you have a $75 trillion portfolio, there's nothing special about it -- it mirrors the market. And since only 5 U.S. banks hold 96 percent of the derivatives held by all US banks, that means the same sort of instruments at the other top four -- JP Morgan Chase, CitiGroup, Goldman Sachs and HSBC USA -- are likewise at risk.

That number, again according to the OCC, is $58.16 trillion -- $55.1 trillion in cross currency swaps, and $3.06 trillion in net credit default swaps.

Again, the exact portion of Eurozone exposure to that amount isn't known. But by comparison, consider that 2010's global GDP was $74.54 trillion, and there are other, similar portfolios at other banks around the world--all in danger.The total face value of all the derivatives in the world? $601 trillion.

We slogged through a rehearsal of this in 2008 when Bear Stearns, Lehman Brothers, and AIG collapsed and threatened to take the global financial system with them. But the sheer magnitude of today's problems is immensely bigger, and the danger is therefore immensely greater.

Just one more set of numbing statistics to give you some perspective: The total 2007 revenues of AIG, of Bear, Stearns, and of Lehman Brothers totaled $215 billion. By comparison the 2010 GDP of Greece alone was $318.1 billion. If you add in Italy -- expected to be next -- the total is about $2 trillion. Defaults like that don't take place in a vacuum.

As William K. Black recently wrote, the coming derivatives turmoil signaled by the Fed when it approved the Merrill/BofA derivatives transfer could be the end of Bank of America. But the problems looming over the economy today are bigger than that, or the fallout from that, because Wall Street and America's banks are doing business today as if nothing had happened on 2008, and fought to kill or modify every law since that tried to prevent a replay.

True, they're not churning out phony, AAA-rated paper based on the fantasy that home prices would rise forever. But blaming the Great Recession on overblown housing prices alone is like blaming a fatal auto accident on the faulty windshield wiper that obstructed the driver's view, while what killed him was the way the car was built. And as it happens, all the structural elements that really caused the crash are still with us, and being used, every day.

This is especially true of the math behind something called Value-at Risk, or VaR, which was and is the basis of pretty much every trading program and deal on Wall Street, even though most economists agree that it doesn't work for those applications.

Because every trading platform is based on VaR, there were and are what are called massive correlations in the market -- similarities, that is, that magnified the market moves in '07-'08 by sending everybody off in the same direction at the same time, selling worthless assets into a falling market, with predictable results.

Those pressures created losses that triggered the asset sales, and the highly-leveraged credit default swaps used to hedge those trades forced -- and will force -- a lot of assets to change hands.

That, together with a market bottleneck caused by a shortage of collateral for deals -- caused by extraordinary demand -- was what really caused the '08 crash. And none of that's changed, anymore than the way senior management's compensation is calculated has changed, despite Paul Volker's best efforts to kill off that book-your-profits-today-and-devil-take-the-hindmost mentality.

I'm not an investment advisor. But it's my guess that, after all of what's coming plays out, a lot of people's portfolios will be in commodities -- mostly rice, beans, and tuna fish.