Simon Johnson Scares Senators On Euro Derivatives Powderkeg
August 1, 2012 • 11:22PM

Senators participating in a Senate Foreign Relations Subcommittee on European Affairs hearing this Wednesday on "The Future of the Eurozone: Outlook and Lessons," were shocked when former IMF official Simon Johnson insisted repeatedly in his testimony that the Euro will not last in its current form, and no one knows how this will set off the derivatives "powderkeg" tied to that Euro, and that therefore, no assurances from Mr. Geithner or any other official that the effect on U.S. banks will be limited should be believed.

Johnson told the hearing that ECB chief Draghi, et al. were kidding themselves; the ECB could not possibly issue enough credit to bail everyone out. The more credit it issues, the more it undermines the credibility of that debt. "Whatever it takes" will not work, he said. We are moving into the most dangerous phase of the Euro now, where "dissolution risk" is dominating. How can anyone sign a contract, if they do not know if the Euro will exist in a year? We are "sitting on a powderkeg of opaque, over-the-counter derivatives transactions linked to the Euribor — a rate already called into question — running in the hundreds of trillions of euros. Johnson told them: No one can tell you what what U.S. bank exposure is to this, or what the effect will be of Greece leaving the Euro — which he put as 90% probable before the end of the year.

Hearing chair Sen. Jeanne Shaheen (D-NH) was clearly stunned. She questioned Johnson on how Mr. Geithner "consistently assures" us that U.S. bank exposure to Europe is "limited." Johnson reiterated what he had said at three different points in the hearing: the complexity of derivatives is such, that not even the institutions who hold them know what their exposure is. It is not possible for Mr. Geithner or any other official to know what the true exposure is.

He repeatedly cited the case of JP Morgan as exemplary. In JPMorgan's own "living will" — which they published before their more than $6 billion loss — they estimated that a $30 billion loss would bankrupt them. The bankruptcy of JPMorgan would be a systemic event, while the stress tests done by federal regulators did not even model the events that we today are all taking as as our basic premise, he said. He told the Senators to read that Morgan "living will," which is public.

Johnson, who on other occasions has supported Glass- Steagall, failed miserably to seize the opportunity he himself created, and did not name Glass Steagall as what must be done, even when asked point-blank what to do about European and other "too big to fail" banks.