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Europe’s debt woes to hit home?

By Sheyna Steiner · Bankrate.com
Friday, July 15, 2011
Posted: 1 pm ET

This week the debt crisis in Europe increasingly featured Italy in addition to the already-fraught economies of Greece, Ireland and Portugal.

The increased possibility of Italy as a potential debt defaulter alarmed many as the Italian economy is the third largest in Europe. The country's tenuous financial position was thrown into stark relief after a public spat between Italian Prime Minister Silvio Berlusconi and the finance minister Giulio Tremonti over austerity measures designed to bring down debt levels.

On July 14, the Italian parliament rushed to approve the austerity measures according to the NPR story, "Italy's lawmakers rush $99 billion austerity plan," but the prospect of even approaching a default shook European stock markets this week.

From the story:

With one of the core European economies teetering on the edge of the euro-zone crisis, the European Union was shaken. Up to now, it has dealt with bailouts for smaller economies on the periphery: Greece, Ireland and Portugal.

Daniel Gros, director of the Centre for European Policy Studies in Brussels, said Italy is too big to fail.

There are a couple ways that a European default could impact the U.S., the most salient of which would be a hit to the stock market.

  • Banking
  • The stock market
  • Currency

Banking

The first is in the banking system. Banks and financial institutions hold debt issued by other countries. If the country can't pay bond holders, the banks could take a loss.

That danger may be mitigated by the fact that the European debt crisis has gone on for so long. Banks and financial institutions have had plenty of time to reduce their exposure and hedge their positions.

On CNN.com, the article "Italian debt woes no threat to U.S. banks" reports that U.S. banks have relatively little direct exposure to bonds issued by the Italian government. But credit default swaps, on the other hand, could be more damaging.

The market for credit default swaps is notoriously opaque. But based on rough estimates from Collins Stewart, U.S. banks have $22.7 billion in Italian credit default swap exposure.

By comparison, banks in France, Germany and the United Kingdom have a combined $11 billion worth of credit default swap exposure to Italy.

But analysts say credit default swaps on Italy are less likely to blow up the way mortgage-backed swaps did in 2008.

The difference is that Italy's problems have been well known for over a year, and banks appear to be much more aware of the risks than they were when the housing market began to unravel. They aren't ignoring those risks either.

Credit default swaps are similar to insurance policies taken out by lenders to protect them in case borrowers default.

According to a Forbes blog from July 15, "Why Europe is really freaked out over a Greek default," one "private estimate reaching us here at BullionVault puts the gross CDS insurance cover at twice Greece's 340 billion euros of outstanding debt."

Someone, several large banking someones, will have to pay out big-time in the event of a default, and not just to bond holders. Anyone can buy credit default swaps, and these naked credit default swaps make up a majority of the market.

When banks lose money, everyone loses money in the form of credit. A July 2 article from The Los Angeles Times, "How Greece's debt crisis affects U.S. investors and consumers," pointed out that if banks rein in lending as the result of losses, global credit markets could wither which in turn could exacerbate the weakness of neighboring economies.

From the story:

… Economists worry about the threat of 'contagion' spreading to other troubled economies, such as Ireland, Portugal and possibly Spain, all of which are stricken with anemic or nonexistent growth and heavy debt.

'Contagion is the real issue, not Greece per se,' said Gary Schlossberg, senior economist at Wells Capital Management.

The stock market

A default on debt by a big economy such as Italy, or even a smaller country such as Greece, would have a huge impact on the stock market.

"The risk of contagion could spark a global sell-off so the biggest risk to Americans is that debt worries spread and undercut our portfolios," says Bankrate's senior financial analyst Greg McBride.

"Contagion would come from soaring interest rates in every market investors deemed to be at risk, which would undercut asset prices globally and be a drag on global economic growth," he says.

Currency

The uncertainty in the European Union has weakened the euro against the dollar. On Tuesday, the Financial Times reported in "Euro suffers as debt concerns persist," the euro fell to a four-month low against the dollar, to $1.3835.

American monetary policy has created a relatively weak dollar in an effort to stimulate the economy by promoting exports. Analysts have said that a weaker euro could hurt American exports. If American goods aren't that great a deal, why buy them?

A decrease in American exports to Europe is probably the least of anyone's concerns though. The fact that the crisis has been a drawn-out affair has at least prepared the world for the situation -- unlike the one going on here.

"None of Europe’s debt issues are new. These are the same issues among the same players – the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) – as last year," says McBride.

"What is far more significant to Americans is a possible debt default by the U.S. That is what really warrants watching," he says.

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