The ongoing debt crisis in the European Union (EU) returned to the top of the headlines this week.

As we pointed out in a previous article (Issue 19 • June 1, 2011), this is the crisis that won’t go away … mainly because it looks as though the EU finance ministers are doing their best to impersonate the Keystone Kops in handling this mess.

Without addressing the underlying imbalances at the heart of the crisis, the European Central Bank (ECB) agreed in July to another temporary EUR109 billion bailout plan for Greece on top of the EUR110 billion loan the country received last year.¹

This marathon debt drama has dragged on since early 2010 because Athens has failed to deliver on its promises of fiscal austerity such as budget cuts and tax increases designed to shore up Greece’s shaky finances.

Greece’s Curtain Call

IMF officials recently warned that “this was Greece’s last chance” to make budget cuts to reign in deficits.²

Voters in Germany and France are not happy their tax dollars are going toward bailing out their spendthrift neighbors. Now, with Athens apparently dragging its feet on financial reforms, EU countries including Germany have threatened to withhold further bailout funds if Athens doesn’t deliver this time around.

Hanging in the balance is a EUR8 billion financial aid payment due to Greece by the end of September. Without it, Greece may run out of cash in a few more weeks, according to officials. Add in the ever-present threat that ratings agencies may once again downgrade the credit risk of Greece, along with several European banks that hold Greek debt, and you have the makings for a volatile final act to this debt drama.³

Chances of Default High … But Already Discounted

Credit default swaps on the PIIGS (see graph) which are designed to pay off for investors in the event of a default, have surged to new record highs as European bank stocks slide to levels not seen since the 2008-09 financial crisis.⁴

As Banyan’s Chief Market Strategist Bob Pavlik told CNBC recently, “The chances that one or more peripheral European countries default is quite high. But what most investors are missing is the defaults have already been priced into the market. The impact, which most investors fear, should be relatively small, and should not be long lasting.”

In other words, financial markets have already done a good job discounting a likely default or restructuring by Greece, and perhaps a few of the other troubled PIIGS, as Bob said. Much of the pain for financial markets has likely been inflicted at this point.

The good news is that, unlike the global credit crunch of 2008-09, this time around most of the collateral damage seems to be centered in Europe and does not appear to be spilling over to US markets to the same degree.

EU Banks Most at Risk

For hard evidence of this, take a look at the graph of average credit default swap prices for a group of EU banks. Remember, a credit default swap is like an insurance policy that protects the holder against default. The higher the CDS price, the higher the risk of default and the more it costs to buy insurance.

As you can see, the risk to European banks has risen dramatically — to levels above the worst of the 2008-09 credit crunch. And it makes perfect sense that EU banks could be most exposed to an EU country default.⁵

According to research by the Federal Reserve Bank of St. Louis, French banks are the biggest holders of PIIGS government debt followed by German lenders. In total, the five PIIGS had $4.1 trillion in total outstanding debt held by global investors when the crisis began in 2010 and Eurozone banks hold about 90 percent of the direct exposure. So a forced Greek default would largely end up being a self-inflicted wound on the EU.⁶

Now take a look at the graph below, which shows credit default swap prices for 34 US banks.

Risk has been rising for American banks, as you would expect considering the level of fear and uncertainty in markets, but risk levels for US banks are well below the peak levels of 2008-09.⁷

US banks have significantly less direct exposure to PIIGS debt relative to their European counterparts. In other words, we believe that the US financial system is likely to feel very little impact from a EU default, and our economy may not be as vulnerable as many investors fear.

The US financial system appears to be a safe haven for European investors amid the EU debt crisis. As the next graph shows, the cash that foreign official and international accounts keep on deposit at the US Federal Reserve has more than doubled this year to more than $100 billion.

Meanwhile, a smaller increase in deposits at the ECB suggests healthy European banks are stashing their cash with the Fed for safe keeping.⁸    

Default May Not be the End of the World

For Greece, credit default swaps indicate a 98 percent chance of a Greek default over the next five years. That sounds pretty much like a done-deal … but the point is that financial markets are already priced accordingly. While this could create a short-term shock to the financial system, a default would not be the end of the world, and it shouldn’t result in much direct damage to US banks.

Look at the numerous examples of Latin American debt debacles in the 1980s. Brazil repeatedly defaulted or restructured its government debts, but today this BRIC nation is considered a leading engine of emerging market growth.

What’s more, as our own Bob Pavlik points out, “A Greek default means we would at least get it over with, and perhaps removing the uncertainty would be a positive for markets.” A default may be painful in the short run, but it may be exactly what Greece needs to permanently reduce its debt burdens and grow again.

Debt Drama Resolution Could be a Positive

The biggest fear factor facing markets and the economy right now remains the EU debt crisis. It seems a sure thing that Greece will default or at least restructure its debts at some point. In the meantime, risks are certainly on the rise, but these risks are mainly centered in Europe.

At the moment, European politicians are squabbling over solutions. If this goes on too long with no resolution, it could be a continuing drag on investor sentiment, which may push markets lower in the near term. However, the EU is already discussing a number of potential solutions including a TARP-like program from the ECB that could recapitalize EU banks and the creation of a Euro bond, which should help relieve debt burdens among the PIIGS. 

At Banyan Partners, we are looking for signs of improving sentiment and watching indicators of financial stress levels during this crisis of confidence. We are trying to determine whether stocks have already corrected enough to discount these fears, and our belief is that markets have fully priced in most of the negative scenarios already.

A resolution to this marathon Greek debt drama … even if it includes default … could be a potential positive catalyst that removes a lot of uncertainty from markets.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Wall Street Journal: Troika Expected to Approve Greek Loan Tranche This Month, 9/12/11
² Ibid
³ Ibid.
⁴ Bloomberg market data, 9/12/11
⁵ Bloomberg market data, 9/13/11
⁶ Federal Reserve Bank of St. Louis: The Regional Economist, October 2010.
⁷ Bloomberg market data, 9/13/11
⁸ Federal Reserve Bank of St. Louis, 9/9/11