Europe crisis revives '08 fears but risks are less

[August 06, 2011]  LOS ANGELES (AP) -- Wild gyrations in the stock market. Big banks holding risky bonds. Fear that toxic assets will contaminate banks and freeze up credit on both sides of the Atlantic.

Wall Street is having a flashback to the panicky days of September and October 2008, when Lehman Brothers collapsed and American International Group needed a bailout that became the biggest on Wall Street -- $182 billion.

This time investors are worried that Europe's debt crisis could slam an already weak U.S. economy. But few analysts think it will do as much damage as the collapse in home prices and mortgage-backed securities did in 2008, when they caused a credit squeeze and banks feared lending to each other.

Compared with the fall of 2008, "our larger banks are in pretty good shape," says Philip Swagel, a former Treasury official who is now an economist at the University of Maryland. "They've rebuilt their capital positions. The institutions that are exposed (to European debt) are in much better shape."

After months of worrying about the risk of default by Greece and Portugal, investors fear that two much bigger countries -- Italy and Spain -- might be unable to meet their debt payments. They also worry that Italian and Spanish banks have loaded up on their countries' government bonds and haven't valued them accurately.

Analysts say a default by an economy as big as Italy's or Spain's would likely throw Europe into recession. That would further strain a fragile U.S. economy and weigh on the global financial system.

If Italy or Spain defaulted, their banks would absorb big losses that could spread to other institutions. French banks have lent heavily to Italian banks, and U.S. banks have lent heavily to French banks.

"You have the potential for a domino effect," says Thomas Abruzzo, head of the North American financial institutions team at Fitch Ratings.

But Abruzzo says he's confident that U.S. banks have hedged much of the risk they've taken in Europe to protect against steep losses. They've also built up their capital -- the financial buffer that protects them against losses.

What's more, the Italian and Spanish government debts are better understood than the exotic mortgage securities at the heart of the 2008 crisis that began in the United States. Then, no one knew which banks were holding how much in mortgage securities or what those securities were worth.

Banks stopped lending to each other. Credit froze up. Panic set in. Corporations that relied on short-term loans faced a debilitating cash crunch.

These days, U.S. corporations are hoarding cash and don't require immediate access to financial markets. Banks also have changed the way they fund themselves. In 2007, they relied heavily on very short-term loans. They needed to be repaid, and replaced, quickly.

When markets seized up, banks quickly ran out of money. Now they have diversified their funding streams with longer-term borrowings. They have more agility to avoid heavy losses.

"Companies now are not in a position where they can be quickly put into a liquidity crisis," said Thomas Tzitzouris, head of fixed income research at Strategas Partners.

The scope of the current trouble, however, is much wider than it was in 2008. The institutions in trouble now are not a few banks or trading firms: They are entire countries.

Italy is the third-largest borrower in the world, with more than $2 trillion in debt. That dwarfs the debt of Lehman Brothers, Bear Stearns and Merrill Lynch, the companies on the brink in 2008.

Measured by the interest rates being charged on Italian debt compared with other countries' debt, investors are putting the odds of an Italian default at higher than 50 percent.

"The markets are saying Italy is on the chopping block," Tzitzouris says.

An Italian default, he says, would bust huge holes in the balance sheets of banks and insurance companies, among others. "Contagion would quickly spread, and you are looking at a severe worldwide recession."

Though U.S. banks are better protected from a credit crisis this time, a deep recession in Europe would hurt a U.S. economy already struggling to grow. The economy expanded at an annual rate of only 0.8 percent in the first half of the year.

July's 9.1 percent unemployment rate was down a tick from June's -- but still stuck at recessionary levels. Consumers, pinched by high gasoline and food prices, are reluctant to spend. And businesses, worried about future sales, are reluctant to hire.

A European default crisis would put a dent in U.S. exports, which have been one of the U.S. economy's few bright spots. The Standard & Poor's 500 companies get about 20 percent of their earnings in Europe.

"In this interconnected world, such a large default would have repercussions on banks and corporations around the world," says Uri Dadush, director of the international economics program at the Carnegie Endowment for International Peace. "We know it's going to be big. But we don't want to find out how big."

[Associated Press; By PAUL WISEMAN and JONATHAN FAHEY]

Copyright 2011 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.