Europe Economy

Here's what's happening in Portugal

Cashin: Prevent contagion in Portugal
Cashin: Prevent contagion in Portugal

As stock markets around the world fell amid a wide-spread sell-off Thursday, many investors were pointing fingers at the European country of Portugal and concerns over the health of one of its lenders as the root cause of the day's troubles.

Here's a brief look at why we should be worried about Portugal.

Why is this happening?

After several months of rumbling, Portuguese conglomerate Espírito Santo International this week delayed payments to some of the holders of its short-term debt securities.

Its Swiss banking arm Banque Privee Espirito Santo is at the center of the concerns after it failed to pay some of its clients earlier this week. The Portuguese media reported the company blamed the issue on an IT mistake, while at the same time making sure that the investors with this exposure were being protected.

Read MorePortugal concerns compound global stock selloff

However by, Wednesday, investors holding the commercial paper issued by Espírito Santo International were being asked to swap their debt securities for shares. And by Thursday, the country's Economico news publication reported that it was seeking judicial protection against its creditors.

A customer uses an automated teller machine (ATM) outside a Banco Espirito Santo SA branch in Lisbon, Portugal.
Mario Proenca | Bloomberg | Getty Images

This comes against the backdrop of reorganization at the conglomerate with investors waiting eagerly for details of a restructuring plan. A general meeting is touted for July 29. Back in May, an audit by the country's central bank showed there were "irregularities" in the accounts of Espírito Santo International with doubts surrounding its financial condition.

What is happening?

All this sparked concerns over another part of the conglomerate – and Portugal's leading bank -- Banco Espirito Santo, with investors speculating that it could be ready to default on its debt. Shares in Banco Espirito Santo were down 19 percent before being suspended by market regulators and Espirito Santo Financial Group dropped 8 percent before also being suspended.

These concerns rolled over into the wider European equity markets, triggering a sell-off across the rest of Europe. In the debt markets, Banco Espirito Santo bonds continue to underperform, with the knock-on effect on Portuguese government bonds, with the yield on its 10-year sovereign debt moving higher throughout Thursday. Still shuddering at the memory of the euro zone financial crisis, investors sent the yields for other euro zone "peripheral" countries – Greece, Italy and Spain -- higher during the morning session.

Read MoreTrading suspended on Banco Espirito Santo: Report

Claus Vistesen, the chief euro zone economist at Pantheon Macroeconomics believes that credit market stress quickly feeds into the sovereign bond markets. Thus, this reinforces the idea that banks and governments are too closely knit in the region, in what many have called a "doom loop" which could place more additional stress in the case of any potential crisis.

Why fears over Portugal may be overblown
Why fears over Portugal may be overblown

What could happen?

Portugal's banking problems could further hit debt markets and make it costlier for its government to borrow. This would make it harder for its economy to recover from the sovereign debt crisis of 2011. However, Jim Iuorio, managing director at TJM Institutional Services, told CNBC that the current problems may be hitting so-called peripheral Europe but wouldn't be a full-blown fear for the greater region until core countries like France were being affected.

"One thing we can almost all agree on is that there probably is some sort of bubble in European peripherals and it could have a destabilizing effect," he said.

The euro zone's periphery had enjoyed a significant bounce-back over the past few months with the yields on some Spanish and Portuguese bonds beating those of even the U.S.

Portugal fears won't be systemic: Pro
Portugal fears won't be systemic: Pro

"Are Portuguese and Greek bonds mispriced?" asked Iuorio, "Of course they are, and it's just a function of every central bank throwing tons of money into this system."

He added that the situation was "worth watching" with the real trigger point in asset markets being when French government bonds begin to sell off.

Analysts Gildas Surry and Geoffroy de Pellegars at French bank BNP Paribas said there was potentially three outcomes for Banco Espirito Santo. These were either an orderly resolution at the bank, a going concern or even a forced liquidation.

Any resolution, they said, could involve the intervention of cash-rich investors – such as sovereign wealth funds from Angola or Venezuela -- which would solve the funding crisis for the parent company, Espírito Santo International . Alternatively, there could be a "fire sale" of assets, in particular the selling of the group's stake in Banco Espirito Santo and other financial entities.

Read MoreWatch French bonds for signs of real trouble: Trader

Analysts at CreditSights, an independent research provider, believed that the Portuguese bank itself should survive and that the contagion to the rest of the southern European banking system should stabilize over time. However, John Raymond, the senior European banks analyst at the company, said that additional capital might have to be found from somewhere, and the European Central Bank would be keen to resolve the issues soon. He added that there could ultimately be losses imposed on low-ranking debt holders of its commercial paper.

"There's uncertainty at the moment," he said on a conference call to clients on Thursday afternoon. "We should see that most of this is within the group, once we get clarity that should help stabilize the rest of the market."

Banco Espírito Santo was not immediately available for comment when contacted by CNBC.

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