Europe Nears Crisis: Weekend at Bernie's Redux

French President Nicolas Sarkozy and German Chancellor Angela Merkel have moved the goal post, again. Although they previously promised that Sunday would produce a game plan for dealing with the European debt crisis, they now say that a comprehensive plan will be birthed at a second EU summit to be held by Wednesday (10/26) at the latest. This weekend might as well be called "Weekend at Bernie's Redux."

In the original movie, two friends discover that someone has been embezzling money from their company. When they inform their boss, Bernie Lomax, he is so apparently pleased that he invites then to his beach house for a weekend of fun. Once they arrive, they discover Bernie is dead. In order not to become suspects of murder, they treat the body as a puppet and make people believe he's still alive.

In our version of the movie, the two friends are France and Germany, and Bernie is Greece. Everyone knows that Greece is dead already -- the country's debt as a percentage of GDP as of 2010 was nearly 150 percent and there's just no way the tiny Greek economy can repay its outstanding debts.

Just like in the original version, there is a struggle between the friends: each has different view as to how to deal with and explain the death of Bernie/Greece. France believes that Europe needs to beef up the bail out fund (EFSF) so that it can borrow directly from the European Central Bank. France is less keen on the bondholders getting less, since so many French banks are up to their têtes in Greek bonds. Conversely, Germany is advocating that bondholders take smaller repayment amounts and also reminds France that borrowing from the ECB would violate European law.

How did we get to this place?

Back in July, the "troika" (the European Union, the European Central Bank and International Monetary Fund) agreed that Greece was dragging the European Union and global financial system down a dangerous road. Greece owed more than it could possibly pay back, so a two-part agreement was put in place:

  1. The folks who lent Greece money (institutions that purchased Greek bonds) would agree to take only 79 percent of what was owed to them

  2. The troika would increase the eurozone bail out fund (EFSF) to 440 billion euros (or approximately $600 billion)

Then, each of the 17 countries that comprise the EU had to agree to those July terms -- hooray for Slovakia, which finally voted yes!

Here's the problem: since July, it's clear that the increased amount of the bail out fund is not sufficient, because Greece is not the only problem in Europe -- of the PIIGS (Portugal, Ireland, Italy, Greece and Spain), it's Italy that's making everyone nervous. Italy owes as much money as Spain, Greece, Portugal and Ireland combined and has the second-highest debt-to-GDP ratio in the eurozone, after Greece. Italy is literally too big to bail. The troika needs to show the global financial system that Italy and Spain will be OK.

Next problem: European banks, which have about $2.5 trillion worth of exposure to the PIIGS, are going to have to take a bigger haircut. Instead of getting 79 percent of what is owed, they're probably going to have to take only 50 percent. If the stuff that they own is only worth half as much, then the banks are essentially insolvent. To continue operating, European banks will need more money, from either the private sector (other banks or investors around the world who are brave enough to lend them money) or from euro bailout fund (more likely).

In other words, guess who's going to bail out Greece and rescue the banks? According to my friend Kim, "once again citizens will pay for the missteps of their governments and financial systems. Here again, we see the preference to heal the banks at the expense of people." Kim, by the way, is a raging capitalist, who completely understands the logic of rescuing the financial system, but she puts a fine point on what we all know: at the end of the day, bail outs are ultimately financed by taxpayers. (The good news is that the $700 billion TARP ended up costing taxpayers much less-more like $20 billion. Of course this doesn't include the more than $150 billion to bail out Fannie Mae and Freddie Mac.)

So why should people in the U.S. care about all of this noise in Europe?

It's all about the chain reaction: U.S. banks have close ties to the European banking system, particularly German, French and U.K. banks. How close? The Congressional Research Service told Congress "Given that U.S. banks have an estimated loan exposure to German and French banks in excess of $1.2 trillion and direct exposure to the PIIGS valued at $641 billion, a collapse of a major European bank could produce similar problems in U.S. institutions." GULP.

Just the $640 billion part represents nearly 5 percent of total U.S. banking assets, so this is a pretty significant problem. A collapse of the eurozone banks would have a direct, negative impact on the U.S. financial system, potentially bringing us back to the fall of 2008, when the global financial system seized up. The net effect would be a plunging stock market; a credit freeze and potentially, a second recession.

All in all, we would all rather party at Bernie's for the weekend, but the facts beg to be addressed. No amount of pretending by Bernie's friends can make those stark realities go away.

Jill Schlesinger is editor-at-large for CBS/Moneywatch. Listen to her Morning Report interview for more analysis, and visit her CBS blog for more coverage.

About the author

Jill Schlesinger is editor-at-large for CBS/MoneyWatch.

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