How EU debt bomb could crater your retirement
Tick-tock ... That's the sound of the debt bomb that could explode if European Union leaders and the European Central Bank don't get their collective acts together before the sun sets Friday on the European summit in Brussels. The survival of the EU is at stake, not to mention global economic growth -- and maybe your retirement account.
As a reminder, here are a few reasons you need to care about Europe:
Banking: If the EU and European banks melt down, U.S. banks will also feel the pain. The Congressional Research Service report to Congress noted, "Given that U.S. banks have an estimated loan exposure to German and French banks in excess of $1.2 trillion and direct exposure to the PIIGS valued at $641 billion, a collapse of a major European bank could produce similar problems in U.S. institutions." In other words, our two financial systems are interconnected. If U.S. banks freeze up, it will be even harder to get a loan for a house, a car or a small business.
U.S. exporters: If the European economy tanks, the U.S. could follow suit. According to the BEA, Europe buys 22 percent of all US exports and so a recession there would hurt our exporters. A euro crisis would cause the U.S. dollar to gain value -- which would only compound the problem for U.S. manufacturers and exporters who'll be able to sell even less to European buyers.
Jobs: If the U.S. economy slows down, there could be another round of job cuts, just at the time where it seemed we were making some incremental progress on the employment front.
Stocks: Remember the August swoon that occurred after the debt-ceiling debacle? If Europe breaks down, August will seem like walk in the park.
What will stop the countdown?
Are you paying attention now? Good. While there may be debate about how to get there, what's clear to anyone following the story is Europe really needs is a lender of last resort. In 2008-2009 financial fiasco, that role was filled by the Federal Reserve. Today, the European Central Bank would be the ideal candidate. But there's a problem: Under Article 123 of the European Treaty, the ECB can't directly fund ailing debtor nations.
"Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as 'national central banks') in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments."
In other words, the ECB is prohibited from being the lender of last resort to troubled EU nations. When times were good, nobody cared about this rule. Large institutions threw money at Portugal, Ireland, Italy, Greece and Spain (the "PIIGS") without thinking twice. As a result, European banks have about $2.5 trillion worth of exposure to the PIIGS, which his has left bank balance sheets bloated with sovereign bonds that are dwindling in value. After conducting stress tests to see how banks would fare if the crisis worsened, the European Banking Authority announced that 31 of 71 European banks would be required to raise an additional 114.7 billion euros.
With the cost of borrowing money escalating for the weakened EU nations and European banks, what's the answer?
According to German Chancellor Angela Merkel and French Prime Minister Nicolas Sarkozy (a k a "Merkozy"), any deal will have to include amending the treaty and then doing anything that would get the ECB to act.
Last week, Mario Draghi, head of the ECB, spoke to the European Parliament and said that if the EU can agree on a fiscal compact that "would enshrine the essence of fiscal rules," it would be easier for the ECB to act more forcefully. Otherwise, the best we'll get from the ECB are half-moves, like the quarter-point interest rate cut to 1 percent and the two temporary long-term refinancing operations.
That's why earlier in the week, Merkozy talked about four elements of a deal that could arise from the EU Summit:
Fiscal discipline via amendments to existing EU treaties: New rules would limit deficits and subject nations to outside European supervision and sanctions
Augmentation of European bailout fund (EFSF): There's approximately 335 billion left in the fund. Experts say that with leverage, the fund could expand by two to three times
IMF involvement: The international monetary fund is likely to help out, though in what manner is unclear
ECB action: Thus far, the European Central Bank has kept Italian and Spanish bond purchases to a minimum.
EU leaders don't need Standard and Poor's to threaten a downgrade to understand what's at risk. All they have to do is watch the cost of borrowing for Italy and Spain (on the rise again) and read the recent ECB report on how much banks across the continent have already borrowed under the emergency measures -- the number stands at $50 billion already, five times the level expected by market insiders. Tick-tock ...
