What could happen to the U.S. if Spain defaults?
25 July 2012
(MoneyWatch) U.S. Treasury Secretary Tim Geithner has
repeatedly said American banks are at low risk from the overseas debt crisis
because they have little direct financial exposure to Europe. That means they
haven't been making loans straight to European borrowers. There is no reason
not to believe him.
Unfortunately, the problem here is the indirect exposure.
U.S. banks have made loans to institutions that have made loans to EU nations,
including Spain. They almost certainly provided loan insurance -- known as
credit default swaps (CDS) -- to these institutions as well. Or they may have
made these loans and CDS to institutions which made the loans and CDS to EU
nations, including Spain.
f Spain defaults, two things would likely happen. First,
many banks will have to account for these now worthless loans. Anyone who
loaned money to those banks will want to know if their loans will be repaid. If
they can't, then they will either have worthless loans of their own to deal
with or, if they bought insurance, they will cash in their CDS. This will
ripple out to other banks and companies just as it did when Lehman Brotners
collapsed in 2008. However, this will likely be on a much, much larger scale.
Economists call this collateral damage "contagion."
If U.S. financial institutions are in as good condition as
we have been told, then they will pay out a lot of money. That will mean they
have less money to lend to American businesses. It is already difficult for
these businesses to get all the funds they need.
If these institutions are in worse condition than they have
let on -- and it is possible some of them are -- then they would be at great
risk of going out of business. (Because of the Federal Deposit Insurance Corp.,
most depositors would still get all of their money back if that happened.)
Either case would severely damage the American economy, which would also be
dealing with a large drop in demand for goods and services. We would certainly
be in a recession, or possibly something worse.
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