European Financial Stability Measures: Recent Developments And U.S. Exposure

Introduction: U.S. Exposure to the European Sovereign Debt Crisis

As recently as July 2011, a number of financial measures have been implemented by institutions and member states of the European Union (the "EU") to address the current sovereign debt crisis and ensure financial stability in the EU. These measures include the extension of loans to the countries known collectively as the "European periphery" — Portugal, Ireland, Italy, Greece, and Spain — and the establishment of inter-governmental facilities to repurchase government bonds in the debt markets. U.S. ownership of the European periphery's sovereign debt has been estimated at $18 billion, although the actual figure may actually be higher, since U.S. pension funds and other institutional investors are not required to disclose these holdings. Although this amount is relatively marginal compared with the holdings of European institutions, the indirect exposure of U.S. institutions to the EU sovereign debt crisis is significantly larger than it first appears. According to recent reports, U.S. ownership of securities in the European periphery's private sector is approximately $70 billion. Ratings downgrades or insolvencies at any of these companies could result in financial losses for U.S. funds and investors. Most importantly, a default or deterioration of the conditions in the European periphery would likely spark a "systemic contagion," as the collapse of Lehman Brothers in September 2008 and the volatility of financial markets in recent days have clearly demonstrated. Similarly, a vicious circle links sovereign risk, bank creditworthiness and the real economy. Banks in the European periphery (as well as banks in other EU countries with large positions in the European periphery's sovereign debt) have in recent weeks seen their funding costs and credit default swap premiums increase exponentially, while their issuance of short-term wholesale debt has fallen sharply. This "collateral damage" is likely to spill over to U.S. institutions as adversity hits the European banks to which these U.S. institutions are creditors. For example, Moody's recently put Crédit Agricole, BNP Paribas and Société Générale on notice for a possible downgrade because of their potential exposure to a Greek default. According to JPMorgan estimates, U.S. money market funds have loans outstanding to French banks of approximately $200 billion (or near 12% of the assets under management). Furthermore, a recent report by Fitch Ratings revealed that the top ten U.S. prime money-market funds have about half of their assets invested in securities issued by European banks. Another serious concern is the exposure that the U.S. might have to the European periphery through credit default swaps ("CDSs") issued by U.S. banks and insurance companies to provide insurance against default to the holders of government bonds. These are the same contracts that brought down insurance behemoth, AIG, in the wake of the 2008 credit crunch. According to the Bank for International Settlements, U.S. banks have approximately $150 billion in credit default swap exposure to the European periphery, which represents the largest portion of such exposure by any country alone. The terms of restructuring of the sovereign debt that are currently being negotiated may trigger a default event under the outstanding CDSs and obligate the U.S. banks to make the payments provided thereunder, with severe consequences for the U.S. financial industry and overall economy. In addition, as U.S. companies are increasingly exposed to international markets, any conditions adversely affecting the European periphery could have negative effects on their business and financial results. Although the majority of U.S. publicly traded companies do not break down their EU revenues on a country-by-country basis in their securities disclosures, research reveals that several U.S. private and public companies have significant revenue exposure to the European periphery, especially in the energy, pharmaceutical and industrial sectors. In addition, the strains in bank funding markets described above could cause the London Interbank Offered Rate ("LIBOR") to spike, which would push up borrowing costs for many non-financial businesses. As a result, U.S. companies and financial institutions need to pay great attention to the public and private finances in the European countries in which they operate, and review their portfolios and business plans to mitigate risks, as any worsening in sovereign debt risk in these countries could affect their European subsidiaries, with negative implications to the U.S. parent company. As negotiations regarding a restructuring of the European periphery's debt enter into a decisive phase, what follows...