Why Wall Street feels Europe's debt woes

WASHINGTON -- Wall Street slumped and stock trading was volatile across the globe Monday from fear that a debt crisis is gathering steam in parts of Europe and the Mediterranean.

These problems are symptoms of a new wound in the global financial crisis, which has taught nations large and small how financially interconnected they are.

Here are some reasons why the European debt crisis matters to Americans.

Q: Aren't debt defaults a thing of the past?

At issue is sovereign debt, bonds issued by individual countries. This is what got Mexico in trouble in 1994-95 and Argentina in 2001-2002. This time, the debt problems are largely in richer nations.

Q: Who is having the problems and why? Greece, Spain and Portugal are in the eye of the storm, but anyone who has lent to these countries or to businesses in them is now at risk. What happens in Europe affects the U.S. banks and Wall Street investors who manage the 401(k) accounts and pension funds of American workers. All three countries are running deep budget deficits - about 10 percent of their gross domestic product.

The U.S. deficit this year is set at 10.6 percent of GDP, but because the U.S. economy is the world's largest and the dollar is the global reserve currency, the U.S. deficit doesn't pose a great short-term risk of financial instability.

The European countries can slash spending. But Spain has high unemployment, and past belt-tightening in Greece has led to social unrest. If the countries shrink from deep cuts in spending, they must either be bailed out by the European Union or try to renegotiate their debts under the threat of default.

Q: So they default - what's the big deal? In normal times, default by a single nation is manageable. The risk now is contagion, not unlike the spread of disease. Mexico's defaults in 1994 and 1995 sparked the tequila crisis; developing nations everywhere faced higher borrowing costs as investors viewed their bonds as riskier after Mexico reneged on its obligations.

Q: How would this contagion spread?

It's already spreading. As concerns began to mount over the past 10 days about financial problems in Greece, investors began betting against other countries with troubling deficits, such as Spain and Portugal. As the crisis in Europe deepens, investors are betting against Norway and Germany because their banks have a lot of outstanding loans to the three troubled nations or businesses in them.

Q: Just how do investors bet against these countries?

Credit-default swaps are exotic insurance-like financial instruments that signal how investors view the risk of a country's debt. Big investors that buy a country's bonds also buy these swaps as protection against default. Investors with no underlying stake in the bonds, however, can also buy swaps and bet against a country.

If investors think a country is financially weak, the cost of insuring the purchase of its bonds goes up, and this also influences the return investors will demand in exchange for assuming the risk of buying a country's bonds.

Q: Why do these swaps sound familiar? They're the same instruments that helped amplify the near-meltdown of the U.S. financial system in September 2008. Investors bet against the bonds of investment banks Bear Stearns and Lehman Brothers, the insurer American International Group and others. In good times, swaps help manage risk. In bad times, they seem to increase fear and panic.

Q: What's the big deal if swaps go bad? Before swaps became so popular, a country defaulted on a bond, then negotiated with its creditors what's called a "haircut." They would agree to repay, say, 70 cents on the dollar and issue new bonds with a higher interest rate for anyone willing to invest anew.

Swaps add a new wrinkle. The swaps market isn't regulated, and there aren't clear settlement mechanisms or exchanges on which these instruments trade. Today's fear is the same as the worries in the fall of 2008 - that a default could trigger disorderly settlement of these bets, and financial chaos could ensue.

Q: So new global financial turmoil coult hurt Americans? Yes. Not only could it hurt exports, one of the few bright spots in a sluggish U.S. recovery, it also could drain European governments of resources to stimulate their economies.