greece euIt looks like the second wave of the financial crisis that began in the U.S. in 2008 is beginning to build. The European Union (EU) contains countries that may have trouble repaying the money they borrowed. And that could mean an EU Troubled Asset Relief Program (TARP).

If those countries were completely independent, this would not be a problem for the rest of the world. But finance crosses political boundaries, and the question facing the rest of the world is whether there's enough of a financial breakwater between Europe and the rest of the world to withstand the building EU tidal wave's force.

Dangerous Exposure

Banks in Europe buy bonds from countries in the EU and elsewhere, and they make short-term loans to EU banks. When EU countries like Greece, Portugal, and Spain get in fiscal trouble, the banks that do business with them get hurt because they have to take losses on the bonds they hold from the troubled countries.

Consider the situation with Greece. According to BloombergBusinessweek, Europe's banks and insurers hold $193 billion in Greek debt, but it's spread out in small chunks so a 70% write-down in the value would not take down an institution. For example, Commerzbank (CRZBY) and ING (ING) "each hold $3.9 billion in Greek government debt."

But banks' exposure to other EU laggards is getting riskier, and it could cost $693 billion to bail them out. Spain and Portugal are seen as being at risk of approaching at least partly Greece's parlous financial condition. As BloombergBusinessweek reported, EU banks' exposure to Portugal is $240 billion and $832 billion to Spain.

Squeeze on Short-Term Financing

Those problematic bonds also serve as collateral for short-term loans by the healthy banks to the ones in the sick countries. This means that the sick countries and their businesses can't get short-term financing. This is the cash that companies and countries use to pay their employees and keep the lights on. And when ratings agencies downgrade a country's claims-paying ability, its bonds are no longer good collateral.

The "good news" for Greece is that according to European Central Bank rules, if Fitch Ratings, Standard & Poor's and Moody's Investors Service (MCO) all cut those bonds to junk, then other banks can't accept it as collateral, according to BloombergBusinessweek. So far only S&P has cut Greece to junk status. But if those other ratings agencies agree with S&P, watch out below.

The fear of an EU-wide wave of capital withdrawal is beginning to be reflected in the capital markets as the price of insuring against a default in the bonds of Greece, Portugal, and Spain rises. Meanwhile, the risk that banks would not be able to accept Greece's and other EU laggards' bonds as collateral for short-term loans raises the specter of bankruptcy for the countries. It will force also these laggard countries' banks to raise more capital.

Spread of the Capital-Withdrawal Wave?

How can such a capital freeze be avoided? The EU is beginning to think about a TARP-like program of its own, which would total 8% of the euro zone's GDP, or $792 billion, according to BloombergBusinessweek. Unfortunately, it looks like the biggest contributor to such a program would be Germany, which is not happy about even participating in a far-smaller Greek bailout.

As we saw in Lehman Brothers' bankruptcy, it's often the inability to get short-term financing that cuts off the oxygen to a company. When a country's oxygen supply is cut off, the question for the rest of the world is how long it will take before the magnitude of the capital-withdrawal wave from the EU slams the rest of the world.

This could be good for the U.S. if investors perceive it as the safest place to invest. But to the extent that U.S. banks are exposed to the EU contagion -- and thus must write-down their exposure to those EU members' government bonds and banks -- the wave of capital that might flow into the U.S. could come at a high price.

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