Despite being more than 5,000 miles from Washington D.C., a default in Athens could trip up the global banking system just enough to tip the U.S. into a recession, investors and economists said.
“Due to financial trading relationships and off-balance sheet exposure to European banks, the U.S. banking system will not go unscathed,” said Michelle Meyer, a Bank of America Merrill Lynch economist, in a note to clients Friday. “If the crisis in Europe escalates, it could be the shock that pushes the U.S. economy into recession."
While this is not the base case predicted by Bank of America, the firm does still prepare its clients for this possibility by laying out how the Greece crisis could quickly become a “Lehman event.” After all, a 50 percent haircut on Greek sovereign debt would mean a very manageable $60 billion, or just two percent, of total bank foreign claims for U.S. banks, according to the report. But that’s just director exposure.
There are five major ways the U.S. is connected: trading counterparty risk and derivative ownership with heavily-exposed European banks, overall market confidence, central bank funding, money-market funds and trade flows.
“Investors become less willing to buy sovereign debt, boosting borrowing costs, which adds to the debt burden and increases chance of an ultimate default,” wrote Meyer. “If banks either take losses or lose funding, bank credit could dry up, weakening the real economy."
The euro fell Monday amid a teleconference between the European Union, the IMF and Greece’s finance minister. They want to make sure Greece has the ability to meet the austerity measures laid out in the rescue package approved by European Union leaders in July. No statement was planned following the call, adding to the jitteriness of investors.
The S&P 500 Index fell in lockstep with the euro Monday, led by shares from the industries that would be most effected by a Europe-led global slowdown: raw materials, energy and industrials. However, U.S. banks were far and away the biggest losers on concern profits would be hurt even further by a global contagion that contains loan demand, curbs trading profits, and grinds merger advisory to a halt.
To Bank of America’s point about central bank funding, many investors and economists have voiced their displeasure at the European Central Bank’s failure to set up a TARP-like mechanism to recapitalize the European banks and stop the bleeding.
“Since no contingency funds have been set aside by the public authorities to recapitalize banks in a crisis, the imminent default of Greece and/or other nations poses a risk to the viability of the banking system,” wrote Carl Weinberg, chief economist for High Frequency Economics in a note to clients Monday. “Lending money to a bankrupt bank cannot make it less insolvent.”
The Maastricht Treaty, which formed the European Union, bars one country from financing the spending of another, so policy makers will have to get creative in their formation of this structure. High Frequency’s Weinberg suggests the countries set up a series of mini-TARPS. They’ll get plenty of time to come up with this plan this week, with the meeting of Group of 20 (G20) nations finance leaders Thursday in Washington.
Many investors believe that recapitalizing the troubled banks in Italy, Ireland, and Greece should take priority over checking up on Greece’s austerity progress. The U.S. arguably was able to recover from the Lehman Brothers collapse more quickly because it focused on these actions first and then turned its sights to deficit reduction after a recovery was already underway.
“It is not only a Greek default, it is the continent-wide austerity measures that pose the biggest threat,” said Brian Kelly of Shelter Harbor Capital. “An earthquake in Japan disrupted the supply chain in the auto sector and the U.S. economy slowed dramatically. The economic earthquake of budget cuts will not be halted by the Atlantic Ocean.”
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