Excerpts:

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

But 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 analysis also shows that Citigroup has the greatest percentage of its exposure potentially protected at 47 percent, while Bank of America has bought the least protection at 12 percent…

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

“The likelihood of actually getting paid out from owning a credit-default swap would be troubling to me if this were my hedge against a systemic shock — especially in a political environment unfriendly to more Wall Street bailouts,” Mark Spitznagel, chief investment officer at Universa Investments, a hedge fund, said through a spokesman…

Analyzing banks’ Europe-related swaps can be like a walk through a fun house, where appearances are distorted and you don’t know what’s around the corner. The degree of disclosure among the five banks differs greatly and not all of them give a complete snapshot of their exposures and offsetting bets.

But that could change in February, when the banks release 2011 annual reports. The Securities and Exchange Commission this month requested that banks now provide fuller and more consistent presentations of their European positions, saying disclosures have lacked transparency, and might therefore be inadequate for investors. Bank representatives last week said they would comply with the guidance…

Credit-default swaps can be dangerous because they have the ability to hit one side of the trade with a demand for a overwhelmingly large payout if a default occurs. Right now, it costs a bank $401,000 a year to insure $10 million of Italian government debt for five years, according to Markit, a data provider. If Italy took a serious turn for the worse, and its government debt seemed in real danger of default, that swap price would rapidly spike higher, as happened with Greece.

If that occurred, 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…

Recognizing this weakness in the derivatives market, finance ministers and central bankers from the Group of 20 leading industrialized nations said in 2009 that they wanted to have clearing in place for all standardized derivatives by the end of 2012.

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(RCS):  Herein lies the danger.  While everything may seem hunky dory from a risk exposure standpoint, assumptions are made that the institution that pledges to pay in case of a default (writers of the CDS contract) will actually pay.  The entire article is a good read and points out one of the big unknowns if Greece, Portugal, or even Italy were to default.