Monday, November 14, 2011

Greece, Italy, and financial stability by James Hamilton
A significant economic contraction in Europe will reduce demand for U.S. exports. But my bigger concern is with international financial linkages. Which financial institutions have made loans or entered into derivatives with exposure to these troubled debts? A recent assessment by the Congressional Research Service estimated that U.S. banks have $641 billion in loan exposure to Portugal, Ireland, Italy, Greece and Spain. But French and German banks themselves have considerable debt to those same countries, and U.S. banks have another $1.2 trillion in loan exposure to German and French banks.
And this is the heart of the problem. Who takes the losses, and if they fall, who do they then bring down in turn? If you're somebody with funds to lend and don't know the answer, in response to these fears what you do is cut back all kinds of lending. If that sounds familiar, it should, because it's exactly this kind of ricocheting financial uncertainty that brought down the world economy in the fall of 2008.
One key indicator to watch for whether we're about to see a replay of those dynamics is the TED spread, which measures the gap between the rate at which banks can borrow Eurodollars* from each other and the U.S. T-bill rate. This has been edging up, but is nowhere near signaling a crisis yet.
Ted spread

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*Note: Wikipedia article on Eurodollar:
Eurodollars are time deposits denominated in U.S. dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins. The term was originally coined for U.S. dollars in European banks, but it expanded over the years to its present definition: a U.S. dollar-denominated deposit in Tokyo or Beijing would be likewise deemed a Eurodollar deposit. There is no connection with the euro currency or the euro zone.

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