Another Financial Crisis in the Making

World-wide stock markets plunged last Thursday as the ongoing sovereign debt crisis in Europe is worsening. The Dow fell 1000 points—its worst ever intraday drop—before rebounding, but still ended down more than 3 percent (as did the S&P 500 and Nasdaq).

Other factors played into this incident as well—a mistaken sell order from Citigroup, unfortunate consequences of machine trading—but the fear of contagion most likely played a significant part in the debacle, and the stocks of financial firms were among the worst performers.

There is a risk that the European interbank market could freeze up again, as happened during the credit crunch of 2007-2009. Several large banks are exposed to the sovereign debt of the PIGS (Portugal, Italy, Greece and Spain—renamed the PIIGS by some commentators to include Ireland in this infamous group of countries).

The major European banks rely heavily upon short-term borrowing, most of it overnight, which makes them fragile as they need to roll over debt every 24 hours. Thus, fear of sovereign default in one or several of the PIGS leads to fear of losses among banks that have lent large sums of money to these countries, which in turn makes it harder for these banks to borrow money.

This all looks very similar to what happened in 2008. As reported by the Financial Times:

“The spectre of counterparty risk, last seen in dramatic form in the wake of the Lehman collapse, is returning to the European banking sector in an early warning sign that some banks may collapse in the wake of the eurozone’s sovereign debt crisis.”

One way to measure credit risk is a financial instrument called credit default swap (CDS), which is a form of credit insurance. During the last couple of years, several countries have seen their sovereign credit risk spike, as commented upon in a previous article, leading to rising prices on CDSs.

As reported by the Financial Times, the “CDS spreads of the seven banks with the most exposure to Greece — Fortis, Dexia, Société Générale, BNP Paribas, ING, Barclays and Deutsche Bank — have all risen to year highs this week. These banks can still access interbank markets, but spread widening this week has alarmed investors.”

Anemic European political leaders keep blaming speculators and instruments for measuring credit risk, a response that was dubbed Europe’s crisis of ideas in the Wall Street Journal. Earlier this year, Greek Prime Minister George Papandreou expressed the view that the crisis is “an attack on the euro zone by certain other interests, political or financial,” whereas the Spanish government, reportedly, ordered an investigation into the alleged “collusion” between American investors and the media to hurt the Spanish economy.

German Chancellor Angela Merkel continues her attack on credit default swaps as well as the rating agencies and calls the crisis “a battle of the politicians against the markets”. However, blaming credit default swaps for Europe’s financial woes is a red herring, at best; yields on government bonds rose before CDS prices, as investors became increasingly worried of the fiscal positions of Greece and the other PIGS. More likely this attack on “speculators” is a way to deflect responsibility for the crisis away from Europe’s faltering political leadership.