How shock waves will hit U.S. if Greece drops euro

(AP) NEW YORK - The unthinkable suddenly looks possible.

Bankers, governments and investors are starting to prepare for Greece to stop using the euro as its currency, a move that could spread turmoil throughout the global financial system.

The worst-case scenario envisions governments defaulting on their debts, a run on European banks and a worldwide credit crunch reminiscent of the financial crisis in the fall of 2008.

A Greek election on Sunday will go a long way toward determining whether it happens. Syriza, a party opposed to the restrictions placed on Greece in exchange for a bailout from European neighbors, could do well.

In the meantime, banks and investors have sketched out the ripple effects if Greece were to leave the euro.

Listen to CBS Charles Osgood's interview about the Greek elections with CBS MoneyWatch Editor-at-Large Jill Schlesinger:

They think the path of a full-blown crisis would start in Greece, quickly move to the rest of Europe and then hit the U.S. Stocks and oil would plunge, the euro would sink against the U.S. dollar, and big banks would uncover losses on complex trades.

ACT I

What would Greece's exit look like? In the worst-case scenario, it starts off messy.

The government resurrects the Greek currency, the drachma, and says each drachma equals one euro. But currency markets would treat it differently. Banks' foreign-exchange experts expect the drachma would plunge to half the value of the euro soon after its debut.

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For Greeks, that would likely mean surging inflation - 35 percent in the first year, according to some estimates. The country is a net importer, and would have to pay more for oil, medical equipment and anything else coming from abroad.

The Greek central bank would also need to print more drachmas once the country got locked out of lending markets, says Athanasios Vamvakidis, foreign exchange strategist at Bank of America-Merrill Lynch in London.

Greece's government and banks currently survive on international aid. "Without access to markets, they have to print money," he says.

That's one reason analysts say the switch to a drachma would lead the country to default on its government debt, possibly triggering losses for the European Central Bank and other international lenders.

Most assume foreign banks would have to write off loans to Greek businesses, too. Why would Greeks pay off foreign debts that effectively double when the drachma drops by half?

Say a small shop owner in Athens has a 50,000 euro business loan from a French bank. She also has 50,000 euro in savings in a Greek bank. The Greek government turns her savings into 50,000 drachma.

If the new currency fell by 50 percent to the euro as expected, her savings would suddenly be worth 25,000 euro. But she would still owe 50,000 euro to the French bank.

European banks would take a direct blow. They've managed to shed much of their Greek debt but still held $65 billion, mainly in loans to Greek corporations, at the end of last year, according to an analysis by Nomura, a financial services company. French banks have the most to lose.

ACT II

Here's where things get scary.

The European Central Bank and European Union would have to persuade bond investors that they will keep Portugal, Spain and Italy from following Greece out the door. Otherwise borrowing costs for those countries would shoot higher.

"If they fail to reassure bond investors, all of the nightmare scenarios come into play," says Robert Shapiro, a former U.S. undersecretary of commerce in the Clinton administration.

Experts agree that the so-called firewall built to stop the crisis from spreading needs more firepower.

Much of the 248 billion euro ($310 billion) left in the European Financial Stability Facility, one European bailout fund, was pledged by the same countries that may wind up needing it, Vamvakidis says.

There's also a European Stability Mechanism that's supposed to be up and running next month, but Germany has yet to sign off on it.

A fast-spreading crisis is known in financial circles as contagion - a term borrowed from medicine and familiar to anyone who has watched a disaster movie about killer viruses on the loose.

"It's like a disease that spreads on contact," says Mark Blythe, professor of international political economy at Brown University.

The bond market, where banks, traders and governments cross paths, provides the setting. If Greece dropped the euro, traders would become more suspicious of Spain, Portugal and Italy and sell those countries' government bonds, pushing their prices down and driving their interest rates up.

Higher borrowing costs squeeze those countries' budgets and push them deeper into recession. Plunging bond prices imperil Europe's already troubled banks, which stockpiled government bonds when they were considered safe.

At this point, the risk would be high for a run on banks throughout Europe. People would stampede to their banks to withdraw what they can. Analysts and investors say that's the biggest fear.

People in Spain, for example, have already seen what's happened in Greece and have started pulling euros out of their accounts in fear the country will switch back to cheaper pesetas.

"People see their banks in trouble," Shapiro says.

In less frantic times, the government would come to the rescue with cash or take over the banks. European countries have already committed to lend up to $125 billion to Spain's banks to help save them.

But all this is happening in the middle of a government debt crisis, and if the crisis gets worse, the Spanish or Italian governments couldn't borrow enough cash from investors to save the day.

"They can't afford to guarantee deposits or money market balances," Shapiro says. "They don't have the ability to borrow internationally from bond markets. Where are they going to get the funds?"

From here, the crisis could easily snowball: Banks could fail, the surviving banks could stop lending to each other, and a credit freeze could shut down Europe as assuredly as a blizzard did last winter.

One way to stem the contagion would be to create so-called eurobonds - bonds backed by all 17 euro countries. They could be sold to raise money for troubled European governments.

Germany, which has the strongest economy of the euro countries, has slowly warmed to the idea but wants weak governments to fix their finances first. "Germany's strength is not infinite," Chancellor Angela Merkel said Thursday.

The International Monetary Fund would probably pitch in. Peter Tchir, who runs TF Market Advisors, worries that the IMF may take a loss on the roughly $28 billion it has already loaned to Greece.

Cash-strapped European governments should be able to turn to the IMF for help, but the IMF's money comes from its 188 member countries. Tchir says that the U.S. and other countries may balk if the IMF asks for help supporting Europe.

"People are happy to put money in if they think they won't lose it," Tchir says. "In this case, the IMF loses money, then everybody gets scared."

ACT III

A full-blown crisis would cross the Atlantic through the dense web of contracts, loans and other financial transactions that tie European banks to those in the U.S., experts say.

Blythe, the professor at Brown, believes credit default swaps, the complex financial instruments made infamous by the 2008 financial crisis, would provide the path.

The swaps were created as a sort of insurance for loans. After lending money to a business or government, investors take out insurance on the loan. If the borrower runs into trouble and can't pay - say, the government of Spain defaults - the banks that sold the insurance cover the loss.

A $2 billion trading loss that JPMorgan Chase revealed in May, traced to a hedge against the Europe crisis, shows just how easy it is for even the safest and savviest of banks to slip up.

And it doesn't even take a default for a credit default swap to go bad.

If traders think other countries will follow Greece, they'll drive up borrowing rates by selling government bonds, which also pushes up the cost of insuring their debt. That's similar to how your neighborhood insurance agent handles a teenage driver.

In the derivatives market, where credit default swaps are traded, there's a twist. When markets treat Spain like a bad credit risk, those who took out insurance on Spanish debt to protect against a default can force the banks that sold the insurance to prove they can make good on the claim.

To do that, banks cash out something else - U.S. government debt, gold, or anything easy to sell. In normal times, it's no big deal. In a crisis, it can lead to a cascade of selling, spreading trouble from one market to another.

Another problem: It's not clear how much U.S. banks have at risk to Europe through credit default swaps, because regulations let banks keep that information a secret.

"You could have American banks up to their necks in CDS liabilities," Blythe says. "We don't even know."

There's a wide variety of other paths the turmoil could take into the U.S.

Money market mutual funds, which hold more than $2.5 trillion, have an estimated 15 percent of their investments in Europe. European banks are also large buyers of U.S. mortgage bonds. If they're forced to sell them, mortgage rates could jump, imperiling the U.S. housing market. Frightened banks might also pull the credit lines companies depend on for global trade.

So, what's the good news? It's hard to find anybody who believes the crisis will get that far.

The bankers planning for a Greek exit say they think European leaders will get scared into action. The Federal Reserve and other central banks learned from the financial crisis in 2008, they believe, and will jump in to stop the nightmare scenario from unfolding.

Just in case the worst comes to pass, analysts at Barclay's have attempted to estimate the fallout. They compare it to the days after the investment bank Lehman Brothers collapsed in September 2008. This time, they project that oil prices would fall to $50, stock markets outside of Europe would plunge 30 percent, and the dollar would soar to trade nearly even with the euro.

Blythe is skeptical that it will get this bad, because he hopes the previous financial crisis has left governments and central banks prepared.

However the Greek story ends, Blythe believes it's bound to be ugly. Putting 17 countries together to share a common currency worked well when Europe prospered. Now that they're struggling, "all the design flaws are becoming apparent," he says. Every solution that's supposed to fix a problem creates another problem.

The proposed $125 billion loan to save Spanish banks, for instance, adds to the debt burden of Spain and other troubled European countries, which sent their borrowing costs higher and put a tighter squeeze on their budgets.

"The euro itself," Blythe says, "is a bloody doomsday machine."