Tim McLaughlin, VP Weichert Financial Services

 http://twitter.com/TimMc86

It seems like each week, the markets have a new focus on a different country that drives volatility; this week the focus is on Italy. Take a look at the week that was: Global Equity markets all rose (and Fixed Income rates sold off) Tuesday when Silvio Berlusconi agreed to resign as Italy’s Prime Minister. That’s because a lot of people think Berlusconi is the reason Italy is teetering on the edge of financial disaster. Wednesday, Equity markets were down because those same people realized that they were wrong. Thursday, another rally as maybe they were right.

The idea was that without Berlusconi, the Italian government will get its fiscal house in order and be able to pay back all the money it has borrowed. Italy depends on borrowed money to service its debt, which is significant, but not huge like that of either Greece or the US. In fact, the nation’s fiscal deficits have actually been lower than what they were projected to be.

So with that said why is the US concerned with Italy? As the International Monetary Fund reports, the problem is a “mounting concern among investors about the two way relationship between sovereign and financial risks, and about prospects for policymakers to craft a convincing and durable crisis resolution framework in the euro area. Without significant progress, there is a risk that market worries could become self-fulfilling, with consequences that could prove difficult to contain”.

In simpler terms, the fear is that the government can’t deal with the deficit. More than anything else, that worry is driving up the cost of borrowing money to service the debt. Despite the news about Berlusconi, on midday Wednesday, Italy’s 10 year bonds were at 7.68% and 2 year notes were yielding 7.10%. The magic number here is 7%. When bond yields for Greece, Portugal and Ireland hit 7%, they all had to call on the European Central Bank and the IMF to bail them out.
But unlike the other three nations, Italy has a huge economy. It is Europe’s third largest, trailing only Germany and France. This has enabled it to borrow a lot of money from other people. As of March non-Italians held $1.1 trillion in Italian bonds. This is more than the combined total of foreign-held bonds for Ireland, Portugal, and Greece. So even with the help of the ECB and the IMF, they probably aren’t going to be able to save Italy by themselves.

So why is this concerning to the US? US banks increased sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish and Italian debt in the first half of 2011, boosting the risk of payouts in the event of defaults. According to the Bank for International Settlement, guarantees provided by US lenders on government, bank and corporate debt to those countries rose by $80.7 billion to $518 billion. Almost all of that was CDS. If Italy defaults, or even just looks like it is in danger of defaulting, institutions are going to want to make sure that the loan guarantors can pay off. The fear is what if the US banks can’t?