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Why Does The U.S. Sneeze When Europe Gets A Cold?

In this photo provided by the German Government Press Office German German Ch...

Photo by Steffen Kugler/Bundesregierung / Getty Images

Above: In this photo provided by the German Government Press Office German German Chancellor Angela Merkel talks to Greek Prime Minister George A. Papandreo (L) and French President Nicolas Sarkozy ahead of a summit of European Union leaders in on July 21, 2011 in Brussels, Belgium.

The crisis in Europe is one of the underlying causes of recent wild swings in U.S. stock markets. U.S. bank stocks in particular suffer badly with any sign that Europe's debt crisis might be worsening.

But the U.S. financial sector's vulnerabilities in Europe are hard to quantify.

"There's a certain amount of knowledge in terms of we can quantify — certain areas of exposure — but the real problem is the unquantifiable, not known," says Jan Randolph, director of sovereign risk for IHS Global Insight. "A lot of investors, a lot of banks, simply don't know the interconnections, who holds what and who's connected to whom."

In Europe, unlike in the U.S., national debt is generally held in banks based in that country. So a large chunk of Greek debt is held by Greek banks, and Irish debt is held by Irish banks.

"As soon as one of the national government bond markets fails, so does the majority of banks in that country," says Jacob Kirkegaard, a research fellow at the Peterson Institute.

Heavily Invested

But the damage isn't isolated. French and German banks held about $27 billion in Greek bonds, according to March 2011 data from the Bank for International Settlements, which tracks bank holdings.

The U.S. banks held less than $2 billion by comparison, but they are big holders of Spanish and Italian bonds, holding about $34 billion, according to a Federal Reserve survey.

That $34 billion represents the U.S. financial sector's direct investments in Spanish and Italian bonds. But that's actually only a small part of its overall exposure. Experts say U.S. banks are more vulnerable in indirect ways that are harder to quantify.

One of those major ties is through investments in French and German banks. U.S. banks had half a trillion dollars invested in the French and German banking systems, according to the Bank for International Settlements.

"Banks by nature do a lot of business with each other," Randolph says. "They're a bit like mountaineers roped up, climbing a mountain. If one gets wobbly, the others get frightened."

That fear has manifested in the marketplace in the form of a higher LIBOR, or London Interbank Offered Rate. That means banks are charging more to lend to each other largely because of the shakiness of European banks, Randolph says.

There are other ways the U.S. financial system intersects with Europe. U.S. money market funds, for example, are heavily invested in European banks — a fact that worries U.S. regulators and lawmakers. In all, the big funds have roughly $1 trillion, or about half of their assets, invested in European banks.

A Question Of Confidence

Another way the systems intersect is through the derivatives market, where U.S. financial institutions are particularly heavy traders of credit default swaps.

Those swaps, which were also popular prior to the subprime mortgage meltdown, effectively function as insurance. Experts say U.S. financial institutions may be insuring a lot of European debt against default. But because there's no central tracking system, no one knows how big that vulnerability might be.

So in the end, Randolph says, quantifying the U.S.'s exposure to Europe's debt crisis is just an educated guess.

The Peterson Institute's Kirkegaard says the money the U.S. has parked in Europe isn't even his biggest worry. "The biggest impact would be one of confidence," he says.

Europe is, after all, also the U.S.'s biggest trading partner. And Kirkegaard says worsening troubles in Europe mean stock market disruptions and further crackdowns on lending by U.S. banks.

With the U.S. economy already perilously close to slipping back into recession, it is simply not strong enough to withstand a European shock, whatever the actual size, he says.

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