The Never Ending Story of European Sovereign Debt Default & Bank Instability

Posted on September 15, 2011

The spiraling financial downfall towards default began with Greece and has spread to Ireland, Portugal, Italy and Spain.  At first it seemed impossible, then unlikely, and now headlines actually predict that Greece is 98 percent likely to default on its sovereign debt.  If Greece defaults, EU leaders and ECB officials will be trying to come up with some kind of a plan for an “orderly insolvency, so the ripple effect would be minimal but its not likely. The debt issues of all the other countries and the general shakiness of the EU region will only increase. This expanding dilemma is disturbing financial markets all over the world, and anxiety grows due to a lack of agreement among the EU nations on how to stop it.  At the moment, even a stop gap decision by the European Financial Stability Facility (EFSF) to purchase euro bonds is in question.

The distress over sovereign debt threatens the financial stability of major and regional European banks, with concern that their holding of sovereign debt bonds as collateral is already impinging on the credit worthiness of the banking system.  Huge quantities of retail, institutional and private deposits have been withdrawn not only from Greek and Irish banks, but from German, French, and Spanish institutions as well.  European banks do not appear to have any trust in each other.  They have cut back traditional lending and financing among themselves. As a result, the ECB has not only become the lender of last resort, it’s the first and sometimes only willing lender capable of short term funding.  However, by accepting these country’s dubious bonds as collateral in exchange for funds, the ECB is amassing tremendous risk.

September 15th, several major Central Banks agreed to a 3 month US dollar lending facility with the intention of supporting the ECB and adding liquidity into the European banking system.  The effects of this kind of action remain to be seen.  What won’t be changing overnight though are the risks the European economic community faces.  If there are sovereign defaults, the ECB will still be left holding junk for collateral, the uncertainty fueling the Euro’s ongoing volatility will persist and the wild roller coaster ride the FX markets have been on will continue.

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Joel L. Borshof


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