4 Ways the U.S. Can Defend Itself Against the European Crisis

Americans don't need to bail out Europe -- they just need to take measures to ensure that panic doesn't strike their banking system

The situation in Europe just gets uglier and uglier. The situation in Greece remains volatile, and now Italy is on the brink of collapse. Imagining a way in which this ends well is becoming an exercise in fantasy. A sort of best-case scenario is a debt restructuring for Greece, Italy, and possibly others. Even if that happens, bondholders will be forced to take deep losses on their debt. And therein lies the danger to the U.S.: those losses could cause another financial crisis that makes its way across the Atlantic. American policymakers need to take measures to prevent that from happening.

A Point of Reference: The Financial Crisis of 2008

To think about how to deal with this problem, let's go back to the financial crisis of 2008. You may recall, it didn't go so well. When the housing bubble burst and home prices began declining, investors freaked out. They weren't sure how much exposure to the housing market banks had, so funding dried up and a credit crunch ensued. When banks faced an inability to roll over their debt, failure loomed.

So the U.S. stepped in through the TARP program. The cash infusions were portrayed as bailouts -- as gifts to the banks. But that's not really how they functioned. In practice, they were more like bridge loans. They provided the banks the capital necessary to calm investor panic. Once the financial sector settled down, the banks were able to raise capital relatively quickly and pay back those loans.

The problem ultimately turned out not to be one of solvency but of liquidity. Although these banks had significant mortgage market exposure, they ultimately would not have failed based on home prices declining. The problem was that their funding dried up due to nervous investors. In short, the crisis wasn't caused by actual mortgage losses, but by panic over the uncertainty surrounding potential mortgage losses.

The second phase of restoring confidence was the stress tests. They were arguably Treasury Secretary Geithner's biggest achievement over the past three years. Once the U.S. weighed in on banks' ability to withstand another shock, the crisis was clearly in the rear-view.

From this experience we should take away one clear lesson: panic is the real enemy here. If the banks could withstand $6.3 trillion in U.S. home value losses, then surely they can withstand a 50% haircut on their limited exposure to $3 trillion in outstanding Greek and Italian debt. Indirect losses will result too, but unless banks have a heavy concentration in European bank debt or sold entirely too much protection against European default, solvency probably isn't a legitimate concern -- especially since banks' capital cushions now exceed pre-2008 crisis levels.

So the question becomes: how does the U.S. assure investors that its banks are not doomed by a European crisis? Policymakers have several potential means of action.

Option 1: The Federal Reserve Steps In

On Wednesday, UC Berkeley economist Brad DeLong wrote a blog post urging the Federal Reserve to take action to fence off U.S. from European contagion. His solution sounds simple enough: the Fed could begin a campaign to purchase European sovereign and bank debt from U.S. institutions. By the Fed absorbing those poisonous securities, investors would become comfortable with U.S. banks' health and a crisis would be averted.

There are a few problems with this plan. First, the Fed generally isn't in the business of losing money. For banks to escape giant losses, the Fed would have to purchase these securities for some amount greater than where they would trade today. This would create nearly instant losses for the Fed -- and losses that would likely be lasting as European debt restructuring or bankruptcies force haircuts on these securities. So for the Fed to help banks here, it would have to take significant losses. Even if this move would serve the greater good, it's hard to imagine the already unpopular Fed wanting to face the public backlash that would surely result as it bails out the banks and takes on billions of dollars in losses.

This also assumes that banks would go along. Remember, the Fed will likely prefer limit its losses by purchasing these securities for a price that would cause banks to post big losses instead. Banks with European exposure are likely keeping their fingers crossed hoping for a European bailout to minimize losses. So those institutions might prefer to take their chances and hope for the best, rather than take deep, immediate losses by selling those securities to the Fed. The Fed cannot force banks to sell these securities.

Option 2: The Treasury Bails Out the U.S. Banks

Obviously, the Treasury could announce an new program to inject capital into the big banks again, like it did with TARP in 2008. As before, this would likely calm investors' fears.

But the political appetite for another bank bailout approaches zero. The Dodd-Frank financial regulation bill did its best to ensure that no more bailouts could ever occur again. Another bailout would take an act of Congress. Considering that it barely managed to agree to avoid its own default in August, the idea that both parties would agree to ensure that big banks don't default seems pretty implausible.

Option 3: Extreme Transparency

One way to cure uncertainty is to, well, provide certainty! That's easier said than done, but it isn't impossible. Regulators could lean on the big banks to reveal a detailed account of all of their European exposure. This would include European sovereign debt held, European bank debt held, and credit-default swaps written to insure European debt or banks.

For example, if some U.S. bank has a net European exposure of $4 billion but it has a capital cushion of $12 billion, then its failure due to the European crisis would be very unlikely. Although indirect exposure (like a loan to a hedge fund with heavy European exposure) could also create losses, those second-order losses will generally be more minor than direct exposure. But to provide further comfort on this possibility, the banks could also reveal any general concentration risk, say more than $1 billion in lending to a single source that could reasonably have significant European exposure.

And here's the important part: make each bank CEO, CFO, and division head attest to the accuracy of this disclosure. Then, have their numbers audited by a third-party accounting firm. This should provide investors with the assurance they need that the banks aren't fibbing. After all, if those bankers are lying after signing an attestation, then they could go to jail.

To be sure, some banks won't be thrilled about putting this information out there. But really, if they have nothing to hide, then doing so would clearly be in their best interest. To the extent that a European crisis could cause investors to question their consequent solvency, the more information those investors have to work with to debunk their own fear, the better.

Option 4: Another Round of Stress Tests

If the banks do stubbornly refuse to make public this much detail about their holdings, then regulators could step in and demand that information for their own analysis. Those stress tests managed to work so well back in 2009 -- why not have another round specifically geared towards a European crisis?

Basically, regulators could demand the same information that Option 3 called for. They could then run their own stress scenarios. They could imagine scenarios of a 20% haircut, a 40% haircut, and a 60% haircut on all European exposure and a bank's concentrated (>$1 billion) lending to potentially vulnerable firms. The government could then publish a verdict on each big bank according to these scenarios for investors to see.

If any bank's capital cannot withstand the 60% stress scenario, then it would probably be well-served to acquire additional capital. But most banks probably could withstand this degree of stress, considering that European exposures are limited and capital levels have grown in recent years. Investors need to have this peace of mind or else panic may ensue.

Any one of these tactics could help in fencing off the U.S. from the problems in Europe. Although U.S. banks will face losses if some of the troubled nations in that region default, in most cases those losses won't be big enough cause a large U.S. bank to become insolvent. One way or another, policymakers need to help investors to become comfortable with the exposure of these banks to Europe. If they don't, then we may be doomed to relive October 2008 all over again -- even if U.S. banks have enough capital to absorb a European crisis, panic could kill the economy again.

Image Credit: REUTERS/Andrew Winning