This week Italy became the latest European country to edge closer to catastrophic default, as interest rates on its 10-year government bonds topped 7 percent. As a point of reference, 10-year U.S. Treasuries are currently cruising at 2.1 percent.
Rates on Italian bonds are so high because global markets believe Italy is at a much higher risk of default than say, the U.S. or Germany, so the Italian government must pay a higher rate of interest to attract buyers.
Italian Prime Minister Silvio Berlusconi announced he'll soon resign in an attempt to mollify world markets. It remains to be seen whether that will work; a recent Barclays Capital report says Italy "may be beyond the point of no return."
U.S. banks have relatively little direct exposure to Italian debts, with $47 billion in exposure, compared to France's $416.4 billion, according to June 2011 data from the Bank for International Settlements via Reuters.
But larger U.S. banks may be carrying vastly more indirect risk from struggling European economies as a result of the credit default swaps, or CDS, they've sold in recent years. From Yalman Onaran at Bloomberg:
The CDS holdings of U.S. banks are almost three times as much as their $181 billion in direct lending to the five countries at the end of June, according to the most recent data available from BIS. Adding CDS raises the total risk to $767 billion, a 20 percent increase over six months, the data show. BIS doesn’t report which firms sold how much, or to whom. A credit-default swap is a contract that requires one party to pay another for the face value of a bond if the issuer defaults.
If the term CDS sounds familiar, it should. The financial instruments, which are basically insurance policies against the default of a particular bond, have threatened U.S. banks before. CDS contracts on mortgage-backed securities nearly brought down insurance giant American International Group, and the rest of the U.S. financial system with it, during the 2008-2009 financial crisis.
So what does that mean for U.S. bank customers? U.S. accountholders are protected by the FDIC up to a limit of $250,000, so should a U.S. bank be dragged under by a full-blown debt crisis in Europe, their deposits would be protected. If you're more comfortable at a bank on firm financial footing, check out Bankrate's Safe & Sound Star Ratings, which rate banks based on their financial fundamentals.
But even if their balances are protected thanks to the U.S. taxpayers, if banks struggle because European debt exposure, U.S. accountholders could feel it. It's no coincidence that as things have grown worse for U.S. banks, things have grown worse for their customers. Banks in desperate need of funds to clean up their balance sheets tend to look for that money wherever they can find it, and that can manifest itself in lower deposit rates for customers, higher checking fees and other negative changes.
What do you think? Are you worried about what's going on in Europe? Do you think your bank could ride out a full-blown European default crisis?
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