the Next Global Credit Crisis, June 18 2011

Washington’s Blog
Preface by Washington’s Blog: Is history repeating? As I’ve previously noted, the second leg of the great depression was caused by European defaults.

Even Alan Greenspan says that the ‘almost certain’ Greece default could cause a US double-dip.
The Next Global Credit Crisis: Why U.S. Banks and Greek Debt Will be the Toxic Trigger
- By Shah Gilani, derivatives expert and Contributing Editor, Money Morning

Will a hidden link between the Greek debt situation and the U.S. banking system ignite the next global credit crisis?

The odds of the “next” global credit crisis are increasing with each new day, and with each new revelation. And escalating fears are hitting worldwide stock markets hard.

Just yesterday (Thursday), Greece’s leaders revealed that the country’s socialist government is on the brink of collapse. Greek protesters – angered by brutal austerity measures that will almost certainly heighten the country’s record 16.2% unemployment rate – are rioting in the streets of Athens.

On Wednesday, Moody’s Investors Service (NYSE: MCO) warned France’s three largest banks that their exposure to Greek debt could lead to credit-rating downgrades. There are even concerns that the European Central Bank (ECB) may be technically insolvent – meaning it wouldn’t survive a global financial meltdown.
Investors are right to be worried.

But with the European banking system’s financial woes currently dominating the headlines, those investors might be very surprised to discover that it’s actually the U.S. financial system that may end up as the real weak link in the event of a Greek debt default.

And investors don’t even know this link exists.

The Scary Facts About Greece’s Finances

Since last May, when the International Monetary Fund (IMF) and Eurozone members ponied up $159 billion (110 billion euros) for a Greek bailout, Greece has had to implement radical austerity measures. Terms of the bailout forced Greece to boost taxes and slash government spending. There was a public outcry, but the country’s citizenry largely went along; it had no choice.

One in three Greek workers is employed by the government. As austerity-mandated layoffs have progressed, Greece’s unemployment rate has zoomed from 11.7% in the first quarter of last year to the record 16.2% rate recently reported.

And given that government spending is still at 46.8% of gross domestic product (GDP), additional budget cuts will be coming – meaning Greece’s national jobless rate is certain to increase.

So is the national anger level.The sometimes-violent demonstrations on Wednesday forced Greece’s Socialist Party Prime Minister George Papandreou to reach out to the opposition party in an effort to form a coalition government.

He was quickly rebuffed, is reshuffling his cabinet and will call for a vote of confidence. A no-confidence vote – pretty much a foregone conclusion at this point – would require new elections to be held quickly.

The Surprising Trigger for the Next Global Credit Crisis?

This kind of leadership chaos is unnerving to stock-and-bond investors around the world – especially since Greece needs an infusion of $85 billion (60 billion euros) by mid-July to remain solvent.

And Wednesday’s announcement by Moody’s isn’t helping. In addition to its warning that France’s three biggest banks may be downgraded, the U.S.-based credit-rating firm made it clear that there were other banks in France, Germany and the rest of Europe that could face the same treatment in the event of a Greek debt default.

All of this is widely known. But the largely untold “rest of the story” is this: If the European banking sector implodes, the U.S. financial system could take an unqualified beating.

Big U.S. banks have been lending generously to banks across Europe. Close to 29% of their lending books during the past two years have gone to their heavyweight European counterparts. While they have pulled back considerably as a result of recent turmoil, U.S. banks are widely believed to have $41 billion of direct exposure to Greece.

The amount of exposure to the rest of Europe is not easily quantifiable. And this U.S. financial system link doesn’t end there: U.S. money-market funds have a hefty European exposure, too.

A recent report in The Wall Street Journal said that the three large banks Moody’s is threatening to downgrade – BNP Paribas SA, Credit Agricole SA, and Societe Generale SA (PINK ADR: SCGLY) – get a significant amount of their short-term funding from America’s money markets.

According to The Journal, about 12% of the loans made by our biggest money-market funds were made to those three banks.

The interconnectedness of U.S. banks and money-market funds to global banks, many of whom are now at risk from a Greek default, is a sobering revelation.

Even the European Central Bank won’t be immune.

Bad News for the ECB?

According to Open Europe, a U.K. think tank, the ECB will be close to insolvency if Greece defaults – or even “restructures” – its outstanding debts.

The ECB has $116 billion (82 billion euros) of equity capital against a balance sheet just shy of $2.84 trillion (2 trillion euros) of “assets” consisting of bonds, loans and “credits”. Of that amount, it holds $637 billion (444 billion euros) of debt paper from the so-called “PIIGS” countries of Portugal, Ireland, Italy, Greece and Spain.

Of that total, approximately $270 billion (190 billion euros) are Greece’s crumbled paper. Open Europe estimates that a 40% to 50% haircut on Greek debt would come close to wiping out the ECB’s capital base. And the spillover from the contagion – the next global credit crisis – would sink the central bank almost overnight.

Lorenzo Bini Smaghi, an ECB executive board member, doesn’t buy the conclusions reached in Open Europe’s rapidly circulating report – telling the WSJ.com blog that they are “fundamentally flawed.”

For instance, on the subject of the ECB’s holding bonds that might fall precipitously, Bini Smaghi said that “not being a liquidity-constrained institution, we can act as a buy-side counterparty in markets where sell-offs are taking place, and our investment in those markets can be held to maturity, so that only default risk could threaten our profit and loss accounts.”

In terms of collateral, the ECB board member said that “assets held as collateral only constitute a guarantee, not a direct exposure. Accordingly, related price decreases could only induce Euro system losses if those decreases took place after the default of the counterparty.”

But here’s what’s frightening: In dismissing claims that the ECB could fail, Bini Smaghi makes arguments that repeatedly rely on the premise that there won’t be any actual defaults.

When talking about the bonds the central bank holds, he opened up the proverbial can of worms by saying that “only default risk could threaten our profit and loss accounts.”

Doesn’t he realize that default is exactly what’s on the table?

It’s the “Euro system losses” that would take place as a result of a Greek default that has the global investing community frightened to death. European contagion spells global contagion.

French President Nicholas Sarkozy is in Germany today (Friday) to meet with German Chancellor Angela Merkel. Not surprisingly, the topic will be the Greek debt crisis. President Sarkozy will be pleading with the German Chancellor to back off Germany’s call for Greek debts to be “restructured.”

The rift between France and Germany, the strongest members of the European Union (EU), could be the straw that breaks the Union’s back. That could certainly mean that the next global credit crisis is fait accompli. And it would also represent a definite end to the global recovery.