European Sovereign Debt Contagion Continues to Spread

by: Tony Daltorio

Surely, many American investors are bewildered by what’s going on in Europe.

They must be thinking to themselves: “Greece, Ireland and Portugal are such small parts of the European economy, what’s the big deal?”

True enough… but the problem isn’t the Greek or Irish economies. The problem centers on their sovereign debt and whether that debt can ever be paid back to their creditors.

And who are Greece’s creditors? Mainly European banks. Banks all across Europe are stuffed to the gills with this paper, which in Greece’s case, is trading at about $0.50 to $0.55 on the dollar.

If European banks are forced to realize these losses, they’ll have insufficient capital to function. They would then need to conduct capital-raising operations from reluctant investors. Or need huge bailouts from European governments, which can’t afford it, in a kind of a vicious circle.

If the contagion spreads to the sovereign debt of larger countries, such as Spain and Italy, the very real fear is that the entire European banking system would become insolvent.

A quick look at the bond markets shows that the contagion has spread from Greece…

  • Irish and Portuguese 10-year bonds are yielding over 11 percent.
  • Italian and Spanish yields were treading water for most of this year.

But now there are signs that their yields are breaking out to the upside. In fact, the 10-year Spanish bond yield has risen to an 11-year high at 5.66%.

Moody’s Downgrades France’s Three Biggest Banks

These interest rate moves may have prompted the credit ratings agency Moody’s to try to get ahead of the curve last week.

Moody’s said it may downgrade the credit ratings of France’s three biggest banks: BNP Paribas (OTCQX:BNPQY), Credit Agricole (OTCPK:CRARY) and Societe Generale (OTCPK:SCGLY).

Moody’s cited the banks’ large exposure to Greek debt as the reason. French banks are major creditors to Greece, with $53 billion in overall net exposure to Greek public and private debt, according to the latest figures from the Bank for International Settlement.

For example, BNP Paribas had five billion euros in exposure to Greek debt at the end of 2010. Societe Generale had 2.5 billion euros in net exposure to Greek government bonds.

In addition to sovereign debt exposure, Credit Agricole and Societe Generale hold majority stakes in local Greek banks.

  • Societe Generale’s 54-percent stake in Geniki Bank gives it 3.4 billion euros worth of loan exposure in Greece.
  • Credit Agricole’s Emporiki Bank had $30.1 billion in outstanding net loans at the end of March.

Investors – Watch Out for Spain and Italy…

There are legitimate concerns that any sort of restructuring of Greek debt will adversely affect European banks and the European financial system. The entire conglomerate may be at risk, as was the U.S. financial structure when Lehman Brothers collapsed in 2008.

Greece, Ireland and Portugal will most likely not bring down the European financial system. But a default or restructuring of their debt will be unpleasant for European banks.

But it’s not catastrophic. They should be able to be successfully re-capitalized and continue to be solvent.

What investors need to look out for is Spain and Italy. These are much larger economies and the exposure to their debt is much larger. Problems in these two countries will make the current difficulties look like a walk in the park.

That’s where American investors who are concerned about the turmoil in Europe need to focus. Keep an eye on the 10-year bond yields in Spain and Italy. If they break out sharply to the upside, look out… rough seas ahead.

Disclosure: None