Earlier today we shared David Einhorn’s second quarter investor letter with you. Einhorn talks extensively about the European debt crisis. Einhorn thinks French banks are exposed the most to a Greek default and the purpose of the official efforts is to hide this problem. Here is what he says:
In truth, the official efforts aren’t really designed to prevent what most people would recognize as a default or losses to bondholders. They are designed to hide a much more ominous problem.
When the German leadership called for the private sector to contribute to the bailout, French President Nicolas Sarkozy declared that there could not be a “credit event.” In layman’s terms, a ‘credit event’ is generally a polite way of saying that you can’t get blood from a stone, and good luck trying to collect. But more notably, as a financial term a ‘credit event’ is an event that would trigger the payout on credit default swaps (CDS).
It is very odd to hear a political leader use such technical jargon. Why would Mr. Sarkozy do this? Perhaps the French banks have enormous exposure to sovereign credit events, and it might not be just a Greek default that they are worried about. According to current banking regulations, sovereign credits are considered “risk-free.” This means that banks can take on as much sovereign credit risk as they like without setting aside any capital. Under such a structure, selling short CDS protection is akin to free money for the banks.
Likely, the real worry is that the first default will expose the fiction that sovereign debt is risk-free. If the authorities permit one default, their credibility to prevent additional defaults will be lost. No one knows just how much aggregate exposure to sovereign debt and CDS is hidden in the banking system, and no one is itching to find out. The European regulators are trying to calm the market by conducting “stress tests” on the banks. This might be more comforting if the stress tests included testing for the possibility of a sovereign default. They do not. What is the point of a stress test that fails to test for the most obvious and visible risk facing the banks?