MSSB: How Greece can roil Europe and the U.S.

There are at least three channels through which Greece's troubles could spread throughout the Euro Zone. First, there is the European banking system, which has exposure to Greek sovereign and corporate debt. Significant losses on the debt could force stressed banks to rebuild capital either by selling liquid financial assets, which would depress market prices and generate additional forced selling, or by restricting credit, which would further depress economic growth. Second, problems could spread through economic channels, particularly trade relationships between Euro Zone economies. Third, contagion could be transmitted through financial markets, with fears of a worst-case scenario creating a “risk-off” market psychology that prompts investors to flee all forms of European sovereign debt and potentially other risk assets as well. Should any one or more of these scenarios come to pass, the difficulties in Europe would likely have a substantial impact on the US and global economies and financial systems. Problems in the financial sector would likely strike first, manifesting themselves in both the banking sector and the capital markets. While US banks have only minimal exposure to Greece itself, their exposure to the rest of the European periphery is far more significant, with the largest banks showing gross exposure as high as 15% to 20% of Tier 1 common equity, a measure of regulatory capital. US regulators are aware of the issue and believe the banks could withstand major problems in Europe; recent Federal Reserve stress tests found that 15 of 19 banks tested could manage a downturn worse than that of 2007-2009, but disagreements persist over the adequacy of the Fed's stress-test scenario. In the capital markets, US prime money market funds could be an area of market focus. These funds hold $1.5 trillion in US savings and have invested heavily in short-term European bank debt, with European holdings recently accounting for roughly one-third of their total assets. In a worst-case scenario, losses on European commercial paper could force one or more funds to “break the buck,” that is, drop the net asset value below $1 as occurred in the case of the Reserve Primary Fund in the fall of 2008 following the bankruptcy of Lehman Brothers. That could spark a run on the funds and make it difficult for US corporations to obtain short-term funding. However, this worst-case possibility should not be misconstrued as the base-case scenario. Another area of significant concern is US pension funds. Even those funds not heavily invested in Europe could be affected, as contagion could result in price declines for many risk assets. Additionally, financial system stresses would likely result in increased credit costs and tighter lending conditions for US businesses and households, thereby exacerbating the economic impact of a European downturn. Moreover, a decline in risk-assets prices could impact a broad spectrum of investors, especially those with less diversified portfolios. From a trade perspective, the EU is the single most important trading partner of the US. The bilateral trade relationship is the world's largest, accounting for trade flows of $3.6 billion per day; in addition, transatlantic investment supports an estimated 7.1 million jobs. A prolonged European recession would severely weaken the United States' largest export market and provide a headwind to its employment outlook at a time when the country is struggling to increase economic growth and create jobs. While strains have already been felt in all of the aforementioned areas, the full impact will ultimately be determined by Europe's efforts to calm financial markets and rebalance its economies. Regardless of the outcome, the sovereign-debt crisis in Europe could shape political discussion in developed economies on how to balance growth and austerity in the years to come.