Europe's debt woes bring up bad 2008 flashbacks

Europe's festering debt troubles are giving Americans bad flashbacks to 2008 when fears over what lurked on banks' balance sheets paralyzed lending and nearly triggered a global depression.

Treasury Secretary Timothy Geithner wants more disclosure about the health of financial firms.

Several Federal Reserve officials said on Thursday they were keeping a wary eye on Europe's problems to ensure they do not obstruct the lending vital to sustaining the recovery.

Some Wall Street analysts worry that Europe is not doing enough to prevent another credit catastrophe.

Money deposited overnight at the European Central Bank rose to a record high of 320 billion euros on Thursday, evidence that European banks are reluctant to lend even though the central bank has offered virtually unlimited short-term cash.

This all sounds a little too familiar to Bob Eisenbeis, chief monetary economist at Cumberland Advisors in Vineland, New Jersey, and a former Fed researcher.

"We fear that European policymakers may be about to make the same mistake U.S. policymakers made in 2008," he said.

As the Fed did when U.S. banks balked at lending in 2008, the ECB is flooding markets with liquidity to try to drive down borrowing costs. Eisenbeis said the ECB should ask one critical question first: "Who is paying those higher rates and why?"

At issue is whether European banks are suffering from liquidity or solvency problems. Is it merely that volatile financial markets are blocking banks from normal funding channels, or are firms so overloaded with potentially bad debts that no one is willing to lend to them?

"When unlimited liquidity provisions are not enough, then it is a solvency crisis," said Lena Komileva, head of G7 market economics at Tullett Prebon in London.

The United States answered the liquidity-or-solvency question by subjecting its largest banks to "stress tests" to determine whether they could withstand a worsening recession.

Many economists have urged Europe to fully disclose results of its own stress testing. The worry is if large capital holes are revealed, there won't be money to fill them.

Half the Problem

Spotting the difference between liquidity and solvency problems isn't easy, and one can beget the other.

When creditors question a firm's solvency, they refuse to lend, which can trigger a short-term cash access problem. Likewise, a bank facing a liquidity problem might be forced into fire sales to raise quick cash, driving down the value of its assets and making it insolvent.

The lesson learned from 2008 is that policymakers must attack both problems at once, with speed and force.

For the United States, that meant the Fed launched a series of emergency short-term lending programs, while Congress approved a $700 billion fund that was used to inject capital into the largest banks in hopes of spurring lending.

The second part was a political headache for then-Treasury Secretary Henry Paulson. The banks remained reluctant to lend, prompting howls of protest that Washington was bailing out fat-cat bankers while credit-starved Main Street suffered.

Raising a similar war chest in Europe could be even more difficult. Germany's objections to bailing out its neighbors led to months of wrangling to secure European approval for a nearly $1 trillion euro stabilization fund.

Asking for a bank bailout fund on top of that would be a nonstarter because most European countries face an electorate "that just does not want to hear of further bailouts," Tullett Prebon's Komileva said.

While such a fund does not appear to be a pressing need, it could quickly become one if Europe's debt troubles worsen.

Brendan Brown, London-based chief economist at Mitsubishi (UFJ) Securities International, put an 80 percent probability on a banking crisis in Spain, Greece and Portugal within the next six to 12 months.

[Source: Reuters, Edt, 03Jun10]

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