Nice article by Charles P. Wallace in the current Fortune about moral hazard in derivatives, involving European banks.
European banks have written credit default swaps on their host government's bonds. It looks like American banks are counterparties to a significant degree: "Overall, U.S. banks may hold two-thirds of the total euro-debt CDS outstanding," according to the article. The U.S. positions are probably largely hedges, but still, even hedged exposure can be devastating, if your counterparty fails when you were counting on them to offset a loss somewhere else in the portfolio.
"French Bank BNP Paribas has sold $4 billion in protection on French government debt, 12% of the global total," the article continues. "Similarly, Italy's Banca Monte dei Paschi di Siena has sold $3 billion worth of protection on Italian government debt. If Italy, say, defaults on its debt, these banks might not be able to pay their American trading partners. 'It's the ultimate moral-hazard trade,' says Peter Tchir, CEO of hedge fund TF Market Advisors. 'If a country defaults on its debts, these European banks domiciled in the same country will also default on their debts and won't pay out, so why not write the protection now and make lots of money?'"
It's logical for the banks to write these contracts, whether or not they expect to make money on them in the long run. After all, the highly-leveraged banks of Europe will generally not be solvent no matter what they do, if their host countries default on their own debt.
