Europe: Inching Towards a Deal
The European debt crisis was the topic for the CBS Evening News last night, which drew an uncharacteristic number of responses from viewers. Here's the segment:
The comments ranged from "I finally get why this is so important" to "stop the doom and gloom reporting" to "are you trying to scare the daylights out of retirement investors?"
Of course I liked the positive ones, but let me address the critics. My guess is that these are the very same people who complained that the media didn't adequately cover the lead up to the US crisis in 2007 and early-2008. The point here is that if European leaders fail to adequately address the spreading debt crisis, they could drag us down a pretty scary path.
The connective tissue of the global economy is the banks -- here's how a chain reaction could occur:
- A default in Greece would cause European banks to take massive losses on the Greek bonds that they own.
- US banks have close ties to the European banking system, particularly German, French, and U.K. banks. How close? The Congressional Research Service estimates that U.S. bank exposure to the European debt crisis is $640 billion, or nearly 5 percent of total U.S. banking assets.
- Major European losses would negative impact U.S. banks, which could seize up lending. American corporations would then have limited access to borrowing, which could trigger more layoffs.
- If the global banking system were to freeze, stock markets across the globe would tank, which would clearly hurt 401 (k) and IRA investors in a similar fashion to what we saw after the Lehman Brothers bankruptcy in October, 2008.
- If the aforementioned chain is triggered, the already-weak recovery could collapse and we could be staring down the barrel of another major recession.
The realization of just how much is at risk has prompted European leaders to finally deal with their crisis. After the marathon weekend of negotiations, leaders said that they have a strategy for addressing the debt crisis, and will provide details of their plan no later than Wednesday. From various leaked reports, this is what appears to be on the table:
- Restructure Greek debt: bondholders agree that Greece will only repay 40-60 percent of what is owed to them (in July, the haircut amount was 21 percent).
- Force European banks to beef-up their assets by requiring a 9 percent capital ratio: those that can't raise the money in the private markets will get government assistance. (Requirement could amount to an additional 100 billion euros ($139 billion).
- Leverage the 440 billion euro European Financial Stability Fund ("EFSF") to 2 trillion: use either (1) an insurance plan where a pool of money is set aside to partially offset losses suffered by purchases of debt of weak countries or (2) a special, separate fund that would be a public-private partnership under which the EFSF would suffer first 20 percent of losses.
