The chances that Europe's monetary and political unions will dissolve seems unlikely. As I've discussed before, simply too much is at stake.
At the same time, however, the possibility is real. And it's for this reason that financial institutions like Citigroup
Estimating Citi's exposure to Europe
Given the economic importance of Europe -- last year, the European Union's 27 member states generated a combined nominal gross domestic product of $17.6 trillion compared to the United States' $15 trillion -- Citi's direct exposure to its most troubled economies is surprisingly limited.
The bank's gross exposure to the so-called PIIGS of Europe (Portugal, Ireland, Italy, Greece, and Spain) amounted to $20.2 billion. According to an earlier New York Times analysis, this lines up with the situation at four of the nation's other largest American banks -- JPMorgan Chase, Bank of America, Goldman Sachs
Source: Citigroup's Second Quarter 2012 Earnings Review.
On a country-by-country basis, Citi's single largest liability is Italy, where it has $10.6 billion on the line, making up over half of the bank's total gross exposure to Europe's troubled peripheral economies. Alternatively, Citi's least significant exposure is to Portugal, where it has a comparatively modest $700 million at risk directly. The average gross exposure to the five countries is $4 billion.
In terms of counterparties, corporations make up the majority, or 57%, of Citi's gross exposure, and financial institutions come in at 12%, followed by the five countries themselves at 6%. The remaining quarter, labeled as "other" by the bank, consists presumably of consumer loans, among other things.
Source: Citigroup's Second Quarter 2012 Earnings Review.
The good news for Citi's shareholders is that much of this risk is hedged.
Generally speaking, there are two ways a bank can do this. First, it can require counterparties to post margin and/or collateral to soften the blow of potential losses. In this case, $3.8 billion of Citi's total gross exposure is ostensibly hedged with margin "posted under legally enforceable margin agreements and collateral pledged under bankruptcy-remote structures" -- the latter are generally single-purpose vehicles that, here, would house collateral akin to an escrow account.
Second, it can buy insurance, typically through a credit default swap, whereby a third-party investor assumes the risk of default for an agreed-upon fee. Citi has used this method to hedge over half, or $10.3 billion, of its gross exposure to the PIIGS of Europe. By comparison, at the beginning of the year, Bank of America had only 12% of its comparable exposure hedged, and much of Morgan Stanley's protection, $1.43 billion, to be precise, was purchased from European banks, arguably defeating its effectiveness.
At the end of the day, in turn, Citi's total net exposure to the five most troubled economies in Europe is a comparatively modest $6 billion -- much less, to be sure, than the $100 billion in questionable mortgages held by its Citi Holdings division.
The real risk of Europe
Of course, to investors who remember the last crisis, which I presume is most of this article's readers, gauging Citi's gross and net exposures to Europe is somewhat of a pointless exercise.
For one thing, an estimate of Citi's gross exposure to these five countries dramatically understates what would happen to the bank if the Continent imploded. To use Citi's own words:
The partial or full break-up of the [European Monetary Union] would be unprecedented and its impact highly uncertain. The exit of one or more countries from the EMU or the dissolution of the EMU could lead to redenomination of obligations of obligors in exiting countries. Any such exit and redenomination would cause uncertainty with respect to outstanding obligations of counterparties and debtors in any exiting country, whether sovereign or otherwise, and lead to complex, lengthy litigation. The resulting uncertainty and market stress could also cause, among other things, severe disruption to equity markets, significant increases in bond yields generally, potential failure or default of financial institutions, including those of systemic importance, a significant decrease in global liquidity, a freeze-up of global credit markets, and worldwide recession.
In addition, any type of hedging would probably turn out to be pointless in the event of a Continental fracture, because Citi's counterparties, particularly with respect to the credit default swaps, could themselves face insolvency. In other words, if Citi runs into trouble, the chances are good that other banks like JPMorgan Chase, Goldman Sachs, and Bank of America will as well.
So, will Citigroup survive Eurogeddon?
Although it's impossible to predict the future, one thing seems certain: Most financial institutions probably wouldn't survive the euro's collapse without the support of central banks. And, lest there be any question, in my opinion, there's little doubt that central banks would indeed step in to quell the chaos.
Does that mean that Citi would survive? Again, while it's impossible to predict the future, I think it would -- though I'm still counting on Europe's leaders to come to a more reasonable resolution.
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