If Rome burns, US will feel the heat

10:30 PM burns No Comments

 

Antonio Calanni / AP

A woman walks past the window of a clothes store announcing 50% discounts in downtown Milan. Italy's borrowing rates spiked to a new euro high as pressure mounted on Premier Silvio Berlusconi to resign.

By John W. Schoen, Senior Producer

The financial fires raging in Europe threatened to consume Italy Monday, as investors fled the country’s debt, driving up borrowing costs and pressuring Premier Silvio Berlusconi to resign.  Unless those fires can be contained, the U.S. and the rest of the world will soon feel the heat.

After multiple failed attempts by Berlusconi’s government to reform Italy’s debt-heavy budget and after weekend reports that the government may fall, the financial markets pummeled Italian bonds Monday morning, sending interest rates approaching 7 percent. At those rates, the cost of periodically rolling over Italy’s $2.6 trillion in outstanding debt would quickly swamp its already strained budget.

Nearly two years after similar broken reform promises by Greece, the epicenter of the current financial crisis, the widening turmoil poses a much bigger threat.

"Italy has much more systemic implications than Greece, its debt is larger than the rest of the periphery put together, it is too big to fail, too big to save,” Thanos Vamvakidis, a financial market analyst at Bank of America Merrill Lynch. “The markets don’t believe Berlusconi at this point.”

To cope with losses expected on Greek debt, European officials are in talks to expand a $320 billion bailout fund to shore up European banks or buy Greek bonds outright. Some analysts have warned that European banks don’t have enough capital to withstand losses on their holdings of Greek debt. A default by Italy, the world’s third largest issuer of government debt behind the U.S. and Japan, would dwarf those losses and swamp even an expanded bailout fund.

The financial crisis sweeping Europe has already taken an economic toll, pushing the euro zone to the brink of recession. Spending cuts by debt-laden governments have put the brakes on growth. Now, weakening consumer and business confidence in the once-strong “core” economies of Germany and France are slowing growth.

On Monday, Germany reported a sharp 2.7 percent contraction in industrial production from the month before, far worse than analysts had been expecting. The report follows other economic indicators showing that the European economy is near, or now entering, a recession.

“The folks who think that the U.S. economy or the financial markets are immune and will simply ride out the storm are dreaming in Technicolor,” Gluskin Sheff chief economist David Rosenberg said Monday.

While U.S. officials insist that American banks are reasonably well insulated from the crisis, the U.S. and European economies are the two largest, most closely interrelated in the world. So are the U.S. and European financial systems.

Roughly half of top U.S. banks surveyed by the Federal Reserve reported having made loans or extending credit to European banks. The findings from a quarterly lending poll released Monday show that, though American banks have relatively small direct exposure to Greek and Italian debt, the financial turmoil in Europe poses a significant overall risk to the U.S. banking system, 

Though U.S. banks and other financial institutions are believed to be relatively better positioned against possible debt defaults than their European counterparts, the collapse of MF Global last weekend highlighted the potential impact of making too many bad bets on European sovereign debt.

Less is known about a form of bond default insurance known as credit default swaps written to backstop the risk of a bond issuer not being able to make payments. U.S. banks have written about $400 billion in CDS contracts on European sovereign debt, according to the Bank for International Settlements. Those payouts would be triggered if Greece or Italy defaults. Because financial institutions are not required to report their CDS holdings, little is known about which banks or investment firms are on the hook, and for how much.

Italian leaders now face the same downward spiral that forced Greece, Ireland and Portugal to seek bailouts from their stronger eurozone counterparts. The yield on Italy's 10-year bonds soared Monday to 6.58 percent, the highest since the euro was established in 1999. That raises the cost of issuing fresh debt, further straining the governments’ already stretched budget.

As the Greek debt crisis has demonstrated, Italian officials face limited options in coping with that spiral. Deep budget cuts have sent Greece’s economy in reverse and cut into tax revenues, forcing the government to cut spending further. The contracting economy also makes it  harder to comply with European conditions for aid that are tied to the ratio of total debt to gross domestic product. As GDP shrinks, that number rises.

Aside from the immediate impact on the U.S., the widening European debt debacle may be a harbinger of what lies ahead for politicians in Washington. The wider issue for the governments of all developed countries is the rising cost of paying for social programs created a generation ago. From Japan to Europe to the U.S., those programs are becoming increasingly unsustainable as life expectancies continue to rise for new retirees.

“The great thing is they are getting to live longer, and it's great to live longer, but it's not free,” said Constance Hunter, chief economist at Aladdin Capital Holdings. “But everybody wants it to be free. They want to still get all of the benefits and promises they had when the life expectancy was 10 or 15 years shorter. So this problem is not going to go away unless we figure out how to address it at its core.”

With the debt crisis threatening Italy and Berlusconi's status up in the air, what's next for the market? Louise Cooper, BGC Partners, discusses.