Q: How does the debt crisis in Europe affect me here in the United States?
A: Even though the saga playing out across the Atlantic primarily involves the slow-growth southern members of the Eurozone, the potential spillover effects are considerable. The recent volatility in U.S. stock markets has partly been because of shifting perceptions of European policymakers' ability and willingness to confront the crisis.
Developments on the continent will impose an additional drag on U.S. economic growth, given the near certainty that Europe will suffer another recession in 2012 that easily could sap half a percentage point from our already anemic growth rate.
But a more obscure linkage poses even greater danger: the possibility of contagion from defaults of the more indebted EU member governments. The instruments of destruction here are credit default swaps, the same complex derivatives at the center of the 2008 banking crisis.
In its simplest form, a credit default swap is an insurance policy on a
bond. Suppose a portfolio manager owned GE bonds due to mature in 2012.
The manager could purchase insurance on the bonds by buying a credit default swap. If GE was unable to redeem the bonds, the swap contract would pay off and make the bondholder whole.
U.S. banks sold default swaps on European government bonds back in the Halcyon days when sovereign defaults were inconceivable. To quote a certain presidential candidate: "oops."
Given the deteriorating credit climate in southern Europe, it is increasingly likely that some of these swap contracts will be triggered.
So far, the International Swaps Dealers Association has let these credit insurers off the hook by declaring the 50 percent Greek write-down of their bonds "voluntary," avoiding a payoff.
But the odds are increasing that an outright default will occur, breaking the tripwire and setting off an explosion of credit insurance claims.
Five U.S. banks issue 97 percent of all default swaps in the United States, and it is nearly impossible to apprehend their full liability.
According to Bloomberg, they report $45 billion in net exposure, claiming to hedge their huge positions by buying offsetting swaps from each other and from the very European banks that are at the epicenter of the crisis.
However, if a country defaults, it is likely that at least one of the European banks will fail, unable to settle up.
That leaves the next bank in the chain holding worthless paper, setting off a global game of musical chairs. In reality, the total exposure at American banks could approach half a trillion dollars.
And these institutions truly are too big to fail. Next stop: government bailouts to stave off a global liquidity crisis.
Sound familiar? Think AIG in 2008, which sold default swaps on subprime debt then received $180 billion in U.S. taxpayer aid to pay off the claims in full. The alternatives were too scary to contemplate.
Much depends on the resolve of Germany and France to pony up whatever is necessary to guarantee that none of the banks on their side of the pond are allowed to fail. Meanwhile, our fate remains closely linked to our European friends.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfree press.com.