Something significant happened last week in Europe that I’m guessing most of my readers overlooked. Ever since the debt crisis hit Europe three years ago, Europe has fallen into very predictable cycle. The cycle goes like this:

  • Phase 1 – A financial crisis emerges.
  • Phase 2 – After dire public warnings that the world as we know it will come to an end if something isn’t done immediately a meeting of European leaders is held.
  • Phase 3 – The meeting is met with hope and trepidation, followed by great relief that an agreement has been reached.
  • Phase 4 – Within a few days of the meeting, possibly as long as month, the apparent solution is exposed for what it is: “a band aid for a gaping wound” and the solution unravels.

Last week this cycle was broken. O yes it began exactly the same way. A crisis loomed: What was to be done with Greece? And Phase 2 kicked in, European leaders met. But this is where the cycle stopped. No alternative was found to solve the crisis. And maybe this is a good thing. Maybe, finally, European leaders are realizing that there is no solution to Greece. It’s kind of like an alcoholic who finally admits to himself he has a drinking problem. Until that happens he has no chance whatsoever of living a life of sobriety.

And now that the European leaders admit that there is no solution to the Greek’s financial problems they can now move onto the next phase which is, “How do we allow Greece to leave the eurozone that will minimize the damage?” It is no longer a question of if the Greeks will leave the eurozone it is only a matter of how to do it so that it minimizes the negative consequences from such an event.

And negative consequences there will be. Even now there is a run on the Greek banks. It reminds me of what happened to Washington Mutual a couple of years ago. One moment it was a healthy going concern and within a couple of weeks depositors had electronically pulled out all their deposits from the bank. What is the rational thing to do in a bank run? The rational thing to do is to participate. And that is what’s happening right now with the Greek banks and there is nothing anyone can do about it. The Greek people aren’t stupid. They’re transferring their money into other currencies that have less risk. It’s way too late for the Greek banks to recover.

The really important question is, “Are U.S. financial institutions prepared for what is happening in Greece?” The answer is “It depends on which banks you’re talking about.”

The vast majority of the American banks have no exposure whatsoever to the Greek financial crisis with the exception of our very largest banks – Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley, Goldman Sachs and Wells Fargo. These six banks have definite exposure to what’s happening in Greece. All reports say that their exposure to Greek insolvency is manageable. If you want to believe what the banks are telling you then we have nothing to be concerned about. Call me a cynic, call me a “glass half-empty” type of guy if you like, but I don’t believe it.

Months ago I reported that American financial institutions had only modest amounts of European sovereign debt but they had significantly more risk with credit default swap exposure. A CDS is just a fancy way of saying that they are insuring those who own sovereign debt that it will not default. For a nice fee they are exposed to enormous risk if they are wrong. I believe this is what happened to J.P. Morgan Chase a couple of weeks ago. They bet wrong and voila, they lost $3 billion. Until Congress outlaws these risky forms of investments all bets are off that these six banks will come out of this crisis unscathed.

Sources: Greece and Banks by David Knox, Cumberland Advisors, May 23, 2012; The Rational Thing To Do In A Bank Run, GK Research, May 17, 2012; A Cycle of European Crisis Management, STRATFOR, May 25, 2012.