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Through the Looking Glass

The economy gets whacked from the other side.



Almost exactly three years ago, American banks kicked off a worldwide financial crisis. Today, European banks are now threatening to do something similar.

Here are the similarities:

  • Credit markets are once again tightening up dramatically. It’s too early to say the markets are frozen, but European banks are having a much tougher time with anything more than overnight financing.
  • As in 2008, the fear originated in a small segment of the financial markets but then radiated out to the rest of the world.  Back then, it began with defaults on American subprime mortgages, spread to broader credit markets, and then hopped to Europe and Asia. This time around, the fear began with a crisis over Greek sovereign debt, spread to bigger eurozone countries, and has now hopped over the Atlantic to this country.
  • In both cases, government policymakers initially responded with half-hearted assistance, but were later forced to escalate as the contagion spread.
  • As in 2008, one big reason for the fear is uncertainty about who is ultimately exposed.  It’s clear that major European banks are holding a lot of bonds issued by Italy and Spain, but no one knows how much danger that poses for U.S. institutions that lend money to the European banks.

For Americans, here’s another parallel.  Even though the United States bank stocks are being clobbered, and even though the U.S. is itself teetering on the edge of a recession, foreign investors are once again piling into U.S. Treasury bonds and driving down long-term interest rates.  Yields on 10-year Treasurys hovered at 2 percent on Friday, just a hair above the record lows they reached on Thursday.

But the differences between today and 2008 are at least as important as the similarities.  Last time around, a financial crisis kicked off a horrific economic downturn that in many ways still persists.  This time around, analysts say, it’s more the opposite: an economic downturn is undermining the banks.

“The similarities are like the similarities between World War I and World War II—lots of casualties and absolutely no fun,’’ said Karen Petrou, managing director of Federal Financial Analytics, a consulting firm in Washington.  “But the causes are different, and the battles are raging in different ways and in different places.”


The good news is that American banks are better capitalized and less directly exposed to Europe’s debt crisis.  The Federal Reserve and other bank regulators forced the big banks to greatly increase and improve the quality of their capital reserves.  And while banks are still holding untold billions of dollars in dubious home mortgages, many of them not yet written down, Wall Street firms have already taken their lumps on the really toxic assets.

Another comforting distinction between then and now is that the financial industry’s use of exotic and opaque financial instruments has declined sharply.  In 2007 and 2008 , banks stretched out their money by managing “special purpose vehicles” and “conduits”—pools of money that were off their balance sheets. Wall Street firms peddled “collateralized debt obligations,” or CDOs—the infamous AAA-rated securities based on the riskiest slices of the worst possible mortgages.  When those couldn’t meet demand, they created “synthetic” CDOs that mirrored the performance of the originals.

Beyond the sheer recklessness of those securities, or their incomprehensible AAA ratings, the tangle of obligations made it impossible for either investors and institutions to know who they could trust as a counterparty.  As a result, the panic didn’t remain confined to owners of subprime mortgage securities.

All of that activity ceased when the market collapsed three years ago, and the securities that still exist have been written down to pennies on the dollar.  European banks are still far from transparent, but sovereign bonds are much simpler instruments than tranches of subprime securities.


The bad news is that the volume of European sovereign debt is huge. The volumes of Greek and Irish debt are comparatively small, but there is well over $2 trillion worth of Italian sovereign debt outstanding and about $1 trillion in Spanish debt outstanding.  The European Central Bank has been buying up bonds of troubled countries to prop up the markets for their bonds, but it doesn’t have the wherewithal to handle a slew of the big countries.

With memories of Lehman Brothers still fresh, European leaders are not about to let a major European bank fail.  But the pressures could easily force European banks to slow down their lending in order to conserve capital, which in turn would slow down what is already anemic growth across much of the European Union.

That economic slowdown would reverberate to the United States, which is now depending on exports rather than domestic consumers for much of its growth.  A stalling economy means more bad times for the banks, which would be on the receiving end of the shock this time around.

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