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Europe's Debt Woes Hit Home

Surely, many American investors are bewildered by what is going on in Europe.

They must think to themselves 'Greece, and even Ireland and Portugal are such small parts of the European economy, what's the big deal'.

True enough...but the problem is not the Greek economy or the Irish economy. The worries all center around their sovereign debt and whether that debt can ever be paid back to their creditors.

And who are Greece's creditors? Mainly European banks. Banks all across Europe are stuffed to the gills with this paper, which in Greece's case, is trading at about 50-55 cents on the dollar.

If European banks are forced to realize these losses, they will have insufficient capital to function. They then would need to conduct capital raising operations from reluctant investors. Or need huge bailouts from European governments which cannot afford it... in a kind of a vicious circle.

If the contagion spreads to the sovereign debt of large countries, such as Spain and Italy, the very real fear is that the entire European banking system becomes insolvent.

A quick look at the bond markets shows that the contagion has spread from Greece. Irish and Portuguese 10-year bonds are yielding over 11 percent.

Italian and Spanish yields had been treading water for most this year. But now there are signs that their yields are breaking out to the upside. In fact, the 10-year Spanish and Italian bond yields have recently risen to multi-year highs.

Moody's Cuts French Banks

These moves in interest rates may have prompted credit ratings agency Moody's to try to get ahead of the curve a few weeks ago.

It said it may downgrade the credit ratings of France's three biggest banks. These banks are: BNP Paribas, Credit Agricole and Societe Generale.

The reason cited by Moody's is the large exposure of these banks to Greek debt. French banks are major creditors to Greece with $53 billion in overall net exposure to Greek public and private debt according to the latest figures from the Bank for International Settlement.

For example, BNP Paribas had 5 billion euros in exposure to Greek debt at the end of 2010. SocGen had 2.5 billion euros in net exposure to Greek government bonds.

In addition to sovereign debt exposure, Credit Agricole and Societe Generale hold majority stakes in local Greek banks. SocGen's 54 percent stake in Geniki Bank gives it 3.4 billion euros worth of loan exposure in Greece. Credit Agricole's Emporiki Bank had $30.1 billion in outstanding net loans at the end of March.

What was surprising is that Moody's did not go further and threaten to downgrade Germany's smaller state-owned banks the landesbanken which are also highly exposed to Greek and other such debt. German banks have direct exposure of $34 billion to Greece.

What Investors Should Look For

There are legitimate concerns that any sort of restructuring of Greek debt will adversely affect European banks and the entire European financial system. The entire system may be at risk as was the US financial system when Lehman Brothers collapsed in 2008.

Greece, and for that matter Ireland and Portugal, will most likely not bring down the European financial system. A default or restructuring of their debt will be unpleasant for European banks.

But it is not catastrophic. They should be able to be successfully re-capitalized and continue to be solvent.

What investors need to look out for is Spain and Italy. These are much larger economies and the exposure to their debt is also much larger. Problems in these two countries will make the current difficulties look like a walk in the park.

That is where American investors concerned about the turmoil in Europe need to focus. Keep an eye on the 10-year bond yields in Spain and Italy. If they break out sharply to the up side, look out...rough seas ahead.

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