Sovereign Debt Crisis Queuing Up Round Two of the Global Financial Crisis

Without question, the sovereign debt crisis is in full swing …

It is unsustainable debt that is threatening to break up the 12-year-old European Monetary Union. And it is unsustainable debt that is threatening default and downgrade to the most ironclad credit in the world: The credit of the United States.

Investors and the media have been intently focused on the Draconian outcomes in store for U.S. markets and consumers, if such an event occurs. But they give little attention to the global implications!

Imagine, if dicey U.S. residential mortgage debt in the U.S. triggered one of the worst global crises on record, then what should we expect to happen to the global economy if U.S. government debt takes a haircut?

A default, however, is a very low probability. What has a higher chance of occurring — S&P calls it a 50/50 shot — is a downgrade to U.S. debt.

That’s why this is a critical time for the entire world …

The loss of “risk-free” status in U.S. government debt would likely spread to other sovereign ratings. After all, ratings are relative — not absolute. Perhaps the more troubling part is the systemic damage it would cause.

What’s more, a downgrade of U.S. creditworthiness has all of the ingredients to ignite …

Round Two in the
Global Financial Crisis

The Bank for International Settlements (BIS) recently wrote a report that exposes the risks banks face to sovereign downgrades.

The report stated:

“In advanced economies, banks often have sizeable exposures to the home sovereign.”

Here in the U.S., banks tend to hold a lot of U.S. government debt. In some cases in Europe, such as Hungary and Poland, all of the sovereign debt at banks is domestic government debt!

Therefore, when sovereign debt gets downgraded, bank creditworthiness tends to be downgraded, too.

Moreover, the BIS points out the vicious circle between the conditions of public finances and those of banks. When bank funding conditions deteriorate, it adversely affects the creditworthiness of sovereign debt because the systemic threat of troubled banks prompts the government to step in with backstops and guarantees. Read 2008.

When these events take place, it impairs the sovereign and weakens the real economy, which in turn affects banks’ funding costs and ultimately their solvency. This scenario has already happened in Europe — bad banks dragging down sovereigns, bad sovereigns dragging down banks. 

And if you think it’s just Europe’s problem, think again!

Every major country has stepped in with support for the euro zone to keep the bubble from popping, in the form of: Funding by the IMF, the buying of troubled European sovereign debt by Japan and China, and access to dollar liquidity extended by the Federal Reserve.

Now the fallout from this vicious cycle is being teed up in the U.S.

But just as Greece, Portugal, Ireland, Italy, Spain and Belgium aren’t just Europe’s problem, the threat of a downgrade to U.S. debt isn’t just a U.S. problem. It would, indeed, create another wave of global financial crisis.

Take a look at the map below from the BIS report. If you’ve forgotten how systemic the fallout surrounding the failure of Lehman Brothers in 2008 was, this will give you a quick reminder of just how interconnected the financial system is globally.

Source: BIS consolidated banking statistics

The size of the circles represents each bank nationality’s share of the total global banking system, in terms of bank to bank claims. The thickness of the arrows represents the size of those claims with foreign banks.

In short, the big yellow circles and the thick gray and black lines means banks around the world are heavily exposed to failing foreign banking institutions.

What Does It Mean
for Currencies?

The two most widely held currencies in the world, the euro and the dollar, are in the latest battle for the title of world’s ugliest. Meanwhile the Swiss franc and New Zealand and Australian dollars are marching to new highs — so is gold.

[Editor’s note: There is always a bull market in at least one currency. And to learn how Bryan is helping his World Currency Trader members position themselves during this global unrest, be sure to watch his latest video.]

Gold has all of the ingredients to continue its climb, given the risks that deteriorating sovereign debt poses to the global banking system. But the three paper currencies that have been enjoying strength are highly vulnerable. The above map spells out big trouble ahead for Swiss and emerging market banks (“Other”).

We know the buildup in private debt was enough to trigger one of the worst global financial crises on record. Now, it’s public debt that’s unraveling! And the banks remain as exposed and vulnerable as ever.

If a U.S. sovereign debt event does occur, expect it to trigger sovereign debt downgrades and defaults around the world. And ironically, it would likely send global capital back to the safest alternative — the U.S. — home of the only capital markets with the depth and liquidity to absorb the wave of global capital.

Regards,

Bryan