By GRETCHEN MORGENSON Published: September 17, 2011
THE debt crisis in Europe has finally, and officially, washed up on American shores. Last week, the mighty Federal Reserve moved to help European banks that have been having trouble finding people who are willing to lend them money.
Some of these banks are growing desperate for dollars. Fearing the worst, investors are pulling back, refusing to roll over the banks’ commercial paper, those short-term i.o.u.’s that are the lifeblood of commerce. Others are refusing to renew certificates of deposit. European banks need this money, in dollars, to extend loans to American companies and to pay their own debts.
Worries over the banks’ exposure to shaky European government debt have unsettled markets over there — shares of big French banks have taken a beating — but it is unclear how much this mess will hurt the economy back here. American stock markets, at least, seem a bit blasé about it all: the Standard & Poor’s 500-stock index rose 5.3 percent last week.
But stock investors have a bad habit of dismissing problems in the credit markets until it is too late. Back in the summer of 2007, the stock market was roaring, despite obvious problems in the mortgage market.
Make no mistake: the troubles of Europe and its debt-weakened banks will imperil the United States. For many, it is no longer a question of whether but when Greece will default on its government debt. How far the sovereign debt crisis might spiral, and its precise ramifications, are unknowable, but some fault lines are evident.
Carl B. Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y., outlined what he sees as the major risks — and they fall into two categories. One is the potential for losses incurred by financial institutions that wrote credit insurance on European government debt and the European banks that own so much of that paper. The other is the likely economic hit as banks in the euro zone curb lending significantly.
A crucial mechanism linking financial players in the United States to the problems in Europe involves credit default swaps, those insurance-like products that did so much damage [ http://www.nytimes.com/2011/06/23/business/global/23swaps.html ] during the 2008 financial crisis. (Think American International Group.)
Billions of dollars in swaps have been written on sovereign debt, guaranteeing that those who bought the insurance will be paid if Greece or other countries default. As of Sept. 9, some $32 billion in net credit insurance exposure was outstanding on debt of Greece, Portugal, Ireland and Spain, according to Markit, a financial data provider. An additional $23.6 billion has been written on Italy’s debt. Billions more in credit insurance have also been written on European banks, many of which hold huge positions in troubled sovereign obligations.
But since these instruments trade in secret, investors don’t know who would be on the hook — as A.I.G. was in its ill-fated mortgage insurance — should a government default or a bank fail.
“If Greece folds its tent and that takes out a big institution, we don’t know who wrote the swaps,” Mr. Weinberg said. “Can they raise the cash to perform on their obligations? Can they take the balance-sheet hits? We have a lot of unknown unknowns.”
Even after what we went through with A.I.G., the huge market in credit default swaps remains unregulated and still operates in the shadows. You can thank big banks that trade these instruments — and their lobbyists — for that.
As for the broader economic effects of Europe’s woes, Mr. Weinberg expects credit around the world to become even scarcer. “Outside the U.S., we never really resumed credit growth since 2009,” he said. “Another hit now would bring credit down and impose a huge squeeze on small businesses throughout Europe and over here also.”
ONE troubling aspect of the euro zone crisis is just how large the European banks’ sovereign debt holdings are. At many institutions, the positions dwarf what American institutions held in mortgage-related securities, for example, when compared to book values.
Why? Regulators encouraged European banks to hold huge amounts of European government debt by letting them account for these investments as if they posed zero risk. That meant the banks didn’t need to set aside a single euro in capital against those holdings.
Now, according to an analysis by Autonomous Research, 43 large European banks hold debt in troubled sovereigns that is equal to 63 percent of those institutions’ book values.
Adding to the peril is that these banks are funded primarily by short-term investors, like buyers of commercial paper, rather than by depositors, as is more often the case with American banks. This was the same problem faced by Bear Stearns and Lehman Brothers, which collapsed after short-term lenders fled in panic.
Measuring the loans made to European banks against their deposits tells the story. Across Europe, according to Autonomous Research, loans to banks exceed their deposits by 6 percent. Among French banks, loans exceed deposits by 19 percent. In Greece, they swamp deposits by 32 percent.
In the United States, by contrast, banks are borrowing less than 90 percent of their deposits, on average.
This is why it is becoming such a problem for European banks that so many short-term lenders are declining to renew when loans come due. Money market funds, traditionally big investors in short-term paper issued by European banks, have been reducing exposures. A recent Fitch Ratings report shows that for the two months ended July 31, the 10 largest United States prime money market funds pared their holdings in European banks by 20.4 percent, in dollar terms. In the same period, the funds cut their exposure to Italian and Spanish banks by 97 percent.
But these money funds, with total assets of $658 billion, held $309 billion in debt obligations issued by European banks. That’s equivalent to 47 percent of these funds’ total assets.
“We’re seeing a lot of the same things in the markets that we saw in the Lehman era,” Mr. Weinberg said, referring to that awful episode three years ago. “I can’t tell you specifically and exactly how the fallout from Europe will pass through to us, but I certainly can’t tell you it won’t.”
Moody's downgraded three of the megabanks saying it's now less likely the government would prop them up. Score one for Dodd-Frank.
By Jennifer Liberto @CNNMoney September 21, 2011: 6:42 PM ET
WASHINGTON (CNNMoney) -- When Moody's downgraded three banks on Wednesday, it gave a big thumbs up to the Dodd-Frank Wall Street reforms that aim to ensure there won't be any more big bank bailouts.
Moody's made clear it believes that the U.S. government isless likely to step in to save a troubled bank, and downgraded Bank of America (BAC, Fortune 500), Wells Fargo (WFC, Fortune 500) and Citigroup (C, Fortune 500).
"It is more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled, as the risks of contagion become less acute," Moody's wrote in its downgrade note of Wells Fargo's stock.
That rationale for the downgrade is music to the ears of leaders who staked their political careers on the Dodd-Frank Act and promised it would end the era of "too big to fail."
Rep. Barney Frank said on Wednesday that he couldn't comment on the value of the ratings.
"I am glad that Moody's recognizes that such large institutions are not 'too big to fail'," said Frank, the Democrat from Massachusetts who helped create the Wall Street reforms.
Even Republicans supported the main catalyst behind the Dodd-Frank Act: to stop future taxpayer bailouts of failing Wall Street banks by giving the federal government better tools to unwind giant banks instead of propping them up.
But in the year since Dodd-Frank became law, some economists and banking analysts have questioned how effective Dodd-Frank can be. Since it only governs the U.S. financial system and the biggest banks cross international borders, Dodd-Frank may not be able to prevent a failing big bank from threatening the global financial system, critics say.
Nevertheless, FDIC took a big step toward ending "too big to fail" earlier this month, when it issued rules requiring big banks to create their own so-called living wills. The banks must create road maps showing regulators how to distribute assets in the event of a failure.
And by next July, Bank of America, Citigroup and Wells Fargo will each have to lay out a plan for their break-up should they become insolvent.
Regulators are also working on rules governing how big the capital cushions should be at the biggest banks.
However, there's still much work to be done before taxpayers can be sure of the end of government guarantees for big banks. Regulators have yet to create the rules that crack down on derivatives or ban banks from using their own accounts to make risky bets.
And Moody's agreed that there's still a chance the U.S. government will have to step up if a bank failure threatens the global economy
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