Monday, June 27, 2011

John Mauldin: The Contagion Risk of Europe

Bernanke gave another press conference after the FOMC meeting this week. Taking his time to address the situation in Europe, and the increased urgency of the crisis in Greece, Bernanke said US bank exposure to Greece was minimal and only indirect, via positions in large, core-nation banks in Germany and France. Raising a red flag, the bearded academic said that money-market mutual funds had substantial exposure to those same banks and could take a big hit if push came to shove in Europe. “A disorderly Greek default would have significant effects on the US” economy, he added.

About the only thing there was seeming consensus on in Europe was that Greece will eventually default. The question is when. European leaders, along with the IMF, have caved and will give Greece €12 billion to tide them over while they debate on finding €70-100 sometime late next month. By some accounts that amount will have to be a lot more. Meanwhile, the ECB is adamant that Greece cannot be allowed to default.

The whole process is somewhat akin to trying to help someone who is drunk by giving them another bottle of whiskey. Trying to cure a problem of too much debt with even more debt is simply irrational, and everyone but Europe’s leaders can see that. So why are they doing it?

Because if Greece is allowed to go, there is real reason to believe that the problems will spread rather quickly to the rest of peripheral Europe. By the way, it is not just French and German banks that US money markets have exposure to; there are a lot of Spanish banks that have issued commercial paper as well. And my sources told me that many of the state-owned German Landesbanks are essentially insolvent, with massive amounts of sovereign debt. By the way, another source notes that US money-market funds are not rolling over the commercial paper to some of the banks (like Spanish ones), so there is a liquidity squeeze coming to European banks in peripheral countries.

The ECB has taken on some €100 billion of Greek, Irish, and Portuguese debt, if I remember the number right. They have capital of only about €10 billion. They want to take on even more debt from the banks, as the banks are using sovereign debt as collateral. The whole process is a way to paper over the fact that many European banks are essentially insolvent if they have to mark to market their Greek debt.