U.S. banks are rely on their insurance for Europe’s Debt exposure

United States banks are betting that their insurance is going to pay out as the European financial crisis threatening a trail of defaults.

Five large American banks, including JPMorgan Chase and Goldman Sachs, have more than $80 billion of exposure to the most economically stressed nations (Italy, Spain, Portugal, Ireland and Greece) in the euro currency zone, according to a New York Times analysis of the banks’ financial disclosures.

These banks have made extensive use of a type of financial insurance, called credit-default swaps, to help them offset any losses that might occur if defaults swamped the five troubled nations. Using these swaps, along with other measures, the five banks have cut their theoretical exposure to the troubled countries by $30 billion, to $50 billion.

The Greek government on Sunday appeared close to a deal with the majority of its creditors that would lead to big write-down in the value of its debt. But even a deal could spawn a series of events that could lead to payouts on Greek credit-default swaps. While the Greek swaps would probably be paid, they represent only part of the $602 billion of swaps that have been written on the five troubled countries.

Some market participants now doubt credit-default swaps would work properly during periods of great financial instability. Credit-default swaps were also a big source of systemic weakness in 2008, when the American International Group (AIG) nearly collapsed because it could not make payments on its side of its swaps contracts.

Credit-default swaps can be dangerous because they have the ability to hit one side of the trade with a demand for an overwhelmingly large payout if a default occurs. The bank that sold the protection might then have to post a lot of cash to ensure it would make good on the swap. Large cash calls like that might drain some banks of liquid assets, causing systemic stress.