How Greek Default Could Lead to a Double-Dip U.S. Recession

by: Investment U

By Justin Dove

As if we didn’t have enough of our own debt problems here.

Last week we were told that the debt crisis in Greece was going to bring the world economy to shambles and the markets shriveled up, bracing for a cataclysm.

Luckily, the markets rebounded from the initial scare, but now it has emerged that a Greek default could still wreak havoc on the United States and investors.

United States Has Little Exposure to Greece

The United States holds very little Greek debt. However many top money market funds in the U.S. have been increasing exposure to European banks that hold the Greek sovereign debt. Commercial banks in the United States are issuing less short-term debt, leading the funds to chase higher-interest commercial paper in Europe.

Fitch Ratings reported that as much as 50 percent of U.S. money market funds are tied up in commercial paper from European banks.

According to a Reuters report, Vanguard Prime, a 110.6 billion fund, held 21 percent of its holdings in European bank debt. In the past six months Vanguard increased its European investment by four percent, citing less U.S. commercial paper and better return in Europe.

As Bloomberg reported, Federal Reserve Chairman Ben Bernanke claims that a Greek default would have little effects on U.S. banks and these money market funds:

“We have asked the banks to essentially do stress tests and ask, looking at all their positions, all their hedges, what would the effect on their capital be if — if Greece defaulted,” Bernanke said to reporters today at a press conference after a meeting of the Federal Open Market Committee. “The answer is that the effects are very small.”

Greek Default Implications for American Investors

The biggest fear is that a default by Greece and subsequent default by any of the European banks could spur a similar situation as in 2008 when American International Group (NYSE:AIG) defaulted on default credit-swap obligations to the tune of $182 billion.

A large catastrophe would likely ensue if one company has issued a large amount of credit default swaps insuring a default by Greece or one of the large European banks affected by Greece. A default would then bankrupt this company and possibly create another AIG fiasco.

The New York Times reported that, at a press conference on Wednesday, Bernanke was asked about derivatives tied to Europe.

“A disorderly default in one of those countries would no doubt roil financial markets globally,” Bernanke said. “It would have a big impact on credit spreads, on stock prices and so on. And so in that respect I think the effects in the United States would be quite significant.”

How European Sovereign Debt Defaults Would Affect Stock Prices

So how would this debt default affect stock prices?

  • Just like in 2008, there would be much less capital for institutions to invest in markets.
  • Once stocks start to fall, institutions and investors will rush to pull out of the market before things hit the bottom. This would speed up and multiply the lowering of the stock markets.
  • The result would be a double-dip recession and could possibly send the United States into even more debt as they try to calm the financial markets and restore the status quo.

“Should we see Spain start to spiral lower,” Chief Economist at World First, Jeremy Cook, told The Telegraph, “then it would make the falls of three years ago look like a picnic.”

This situation will unfold over the next few months as the eurozone looks to strike a bailout and avoid any of these dire scenarios.

In the meantime, the European Union asked the largest banks in Europe to quantify the damage of a Greek default. This stress-test is scheduled for release on July 13. Many analysts predict that the European Union will look to stall a decision on a bailout or a default until the results of the stress-test show a more accurate portrayal of the longterm effects.

So, stay tuned as we could be in store for part two of the global financial crisis.

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