European Union Debt Crisis Stings France, Putting U.S. Banks at Risk

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While investors in the United States have been preoccupied with the debt-ceiling crisis and volatile stock markets, the European Union debt crisis has worsened.

Now France is under suspicion, and if its debt troubles spiral out of control, then there's a good chance the country will take U.S. banks down with it.

Despite denials from the major ratings agencies, some believe France could be in danger of losing its AAA credit rating, just as the United States did recently.

In fact, it was Standard & Poor's unprecedented downgrade of the United States that put investors on notice that no nation was safe. France became a target because many of its large banks hold a lot of debt from troubled nations like Greece, and because France has a lot of debt of its own.

The cost of insuring French sovereign debt via credit default swaps edged up last week as rumors swirled and concerns accelerated.

French sovereign debt has grown alarmingly quickly, rising from just 64% of its gross domestic product (GDP) in 2007 to 85.3% of GDP this year, according to International Monetary Fund (IMF) estimates.

A weakening French economy - on Friday the French statistics office reported that second quarter GDP growth was zero - and inadequate government policies have added to investor jitters about the country's ability to repay its debt.

"We've been really cautious, and the sovereign crisis is now escalating," Philip Finch, global bank strategist for UBS AG (NYSE: UBS), told The New York Times. "It boils down to a crisis of confidence. We haven't seen policy makers come out with a plan that is viewed as comprehensive, coordinated and credible."

U.S. Banks Exposed

Such worries have crushed the stocks of French banks in recent days, with financial giant Societe Generale's (PINK ADR: SCGLY) stock falling 14.7% on Wednesday alone.

That raised concerns about the exposure of U.S. banks to debt problems not just in France, but also in the troubled European "PIIGS" (Portugal, Italy, Ireland, Greece and Spain) where it all started.

Most U.S. bank stocks were down Wednesday much further than the 4% overall drop in the markets. Bank of America Corp. (NYSE: BAC) fell almost 11%; Citigroup Inc. (NYSE: C) 10.5%; Goldman Sachs Group Inc. (NYSE: GS) 10% and Morgan Stanley (NYSE: MS) 9.7%.

"The largely untold 'rest of the story' is this: If the European banking sector implodes, the U.S. financial system could take an unqualified beating," Money MorningContributing Editor Shah Gilani said recently. "Big U.S. banks have been lending generously to banks across Europe. Close to 29% of their lending books during the past two years have gone to their heavyweight European counterparts. While they have pulled back considerably as a result of recent turmoil, U.S. banks are widely believed to have $41 billion of direct exposure to Greece."

Not only that, but many U.S. banks have indirect exposure to Europe's sovereign debt via credit default swaps - an insurance derivative that contributed significantly to the 2008 financial crisis - they bought on the large European banks that hold enormous amounts of debt from the PIIGS nations.

"Major American banks are far more heavily exposed to PIIGS debt than first appears," John Browne,Senior Market Strategist at Euro Pacific Capital, wrote in a recent report. "It's as if they have learned nothing."

Spain and Italy

Apart from France, fresh debt problems in Spain and Italy cropped up last week, forcing the European Central Bank (ECB) to buy bonds from both countries to push down rising interest rates.

Problems with all three countries are worrisome because their economies are significantly larger than those nations that already have received bailouts - Greece, Portugal and Ireland. Spain is the fourth-largest economy in the Eurozone, Italy is the third largest, and France is the second largest.

"If there is a significant problem in Spain and Italy, then this is going to impact the rest of theeuro zone, the banking system and the core," Andrew Balls, head of Europeanportfolio managementat Pacific Investment Management Co., said in an interview on Bloomberg Television.

Back in July Money Morning Chief Investment Strategist Keith Fitz-Gerald warned that the European Union's debt crisis would spread to the bigger countries.

Fitz-Gerald said credit-default-swap raiders would "go after Spain, Italy, and France when they're done with Greece, Ireland, and Portugal" because "the concentration of risk is a target-rich environment for major trading houses that have grown so powerful they can attack entire countries, much the way the bond vigilantes attacked debt in the 1990s as a means of raising rates."

The European Union debt crisis presents problems similar to the debt and deficit issues in the United States, but with most countries farther down the road, government action is all the more urgent.

"There will be a need for the governments to act quickly and to deliver strong actions quickly," Frederic Pretet, a Paris-based fixed-income strategist with the Bank of Nova Scotia, told The Globe and Mail. "... The market now has lost the confidence in central banks, in governments in general."

Tomorrow German Chancellor Angela Merkel will meet with French President Nicolas Sarkozy in Paris to try to devise some sort of solution to the European Union debt crisis. Although many in Europe have placed high hopes on the meeting, the two leaders have few options and face domestic pressures likely to pull them in opposite directions.

But the pressure to take bold steps is just as strong. If Europe's politicians don't take the necessary actions - and soon - the European Union debt crisis will keep getting worse, disrupting global equity markets and adding to the stress on a U.S. economy that can't take much more.

"Investors are hugely worried about the spread of the [European] debt contagion and the economic status of the U.S. Each sell-off is effectively a cry for help to politicians and central banks to reach a solution to the debt crisis," Jimmy Yates, head of equities at CMC Markets, told Reuters.

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