Europe's Debt Crisis Won't End Until Greece Defaults

Allowing deeply indebted European countries the chance to restructure their obligations seems to be the most direct approach to resolving the problem, yet has been met with resistance that likely will only prolong the crisis.

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The reason: What once was thought to be a minor problem involving only some smaller peripheral nations in the European Union is now increasingly being recognized as a global train wreck about to happen.

"The problem in Europe is that the banking and national interests have been uncommonly incestuous over the years with banks in France owning the debts of companies in Spain and Spanish sovereign debt, while the banks in Spain own the debts of French companies and the French sovereign," Dennis Gartman, hedge fund manager and author of The Gartman Letter, wrote Friday. "In that environment, as one area of the economy contracts, others do also in a rush to liquidity and to the detriment of all."

The eurozone debt dilemma has been one of the root causes of market turmoil over the past two months, even though the problems have been known since at least early 2010.

Until recently, the popular narrative was that the debt burdens in smaller nations like Greece and Italy would be contained and not cause widespread contagion. That belief, though, has waned amid revelations that some European Union banks are having trouble raising capital. The ability to raise money would be critical in the event of defaults, as banks holding the restructured debt would have to recapitalize.

Suddenly, a problem that looked small and manageable now has much broader implications.

"We are finding out here that all economic activity requires a leap of faith and a sense of psychological assent that can shred at a moment’s notice, taking the cloth of society and tearing it asunder," Gartman said. "This is the perfect storm of a crisis of confidence and at the moment all confidence is lacking and waning."

Dual reports this week indicating that a European bank had borrowed $500 million from the European Central Bank, and that the Federal Reserve was looking into the stability of the EU financial system, helped shake confidence further.

The market already had been in the midst of a seven-week rout fueled by the stalemate in Washington over the debt ceiling and concerns that the US was heading back into recession.

The overhang of the eurozone crisis has fueled anticipation that economic problems are accelerating—and is drawing calls from numerous quarters that the EU stop denying the severity of the debt problem and start employing solutions.

The idea is that once Greece defaults the country, and others in the same boat, will be able to restructure their debts in an affordable manner. While the cascading defaults will cause pain, they also will pave a way back to stability for the indebted countries.

"How does this thing end? It ends when the politicians stop kicking the can down the road and they allow Greece to default and they allow Greece to exit the euro," William Browder, CEO of Hermitage Capital Management, told CNBC. "At the end of the day, I don't know how many cans they're going to kick down the road."

The extent of contagion from allowing a default, though, is an unknown, making employing a solution elusive.

One estimate is that the ECB has a 444 billion-euro ($634 billion) total exposure to the peripheral PIIGS—Portugal, Italy, Ireland, Greece and Spain.

On the US side, domestic banks have little direct debt exposure to PIIGS debt but they do have counterparty risk to European banks, which analyst Dick Bove at Rochdale Securities recently put at just over $190 billion, including about $10 billion from Greece.

Greece has gone to the ECB for about 60 billion euros in funding to cover a loss in private-sector deposits. However, Italy also has sought funding even though it has suffered no drop-off in deposits, a move that added to the mystery of how deep the debt problem runs.

"The latter is also the key reason why the Italian crisis has triggered global risk aversion and stressed other markets as well," analysts at Bank of America Merrill Lynch said in a note.

That stress is likely to continue until policymakers are willing to grapple with the difficult decisions that ultimately will have to be made.

"We hear rumors of problems in funding, on the part of various European banks, from the largest to the smallest and we do not doubt that for a moment," Gartman wrote. "Of course some banks are finding it difficult—if not nearly impossible—to fund themselves. We are at that moment in time when the strangest things take place."