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European Banking Crisis Would Have Big Impact in U.S.

Jeremy Glaser

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. European banks took another big tumble on Friday. I'm here with associate director Matt Warren to discuss the cause of the fall and what Europe might do to try to keep the banks stable. Matt, thanks for joining me today.

Matthew Warren: Good to be with you.

Glaser: So first off, it seems like after last weekend, where they worked all weekend to get this bailout, that the banks were going to look stabilized. There was a huge rally. What caused this reversal of sentiment today?

Warren: So that was supposed to be the "shock and awe" campaign, to try to stabilize the situation, put in a firewall. There's a lot of money involved, and a lot of parties involved, so you had the IMF taking a big share of the proposed loan scheme.

In my mind, that's a step in the right direction. The problem is that they were going to buy some sovereign debt at the ECB, but they've been sterilizing those funds. So in other words, they have not resorted to printing money yet, and I think that's what the market's kind of waiting for, in my opinion.

Glaser: Do you think that's something that's politically possible right now in Europe, or is the ECB just going to say, "No," and try to defend their independence?

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Warren: There's political difficulties at the ECB, and then with the loan guarantees as well. I think part of the reason they held back might very well be for political reasons. But you get closer and closer to the edge and look into the abyss, I think if things do get bad enough, they'll be forced to act. I think that will be the likely scenario is things continue to deteriorate.

If they were to go ahead and print some money, do some quantitative easing, and buy a package of sovereign debt really concentrating on the most troubled nations, that would send a strong signal to the market that they're trying to force these rates lower, and basically putting more money into the system and forcing investors back into risk assets.

And really, you have a situation where, if you're a market player, your incentive is to act first and get out of these bonds. Really, the only way to turn that around is really by forceful intervention by a third party, in my opinion. Otherwise it could continue to spiral out of the control.

Glaser: If they do this quantitative easing program, is that going to solve any of the structural issues that are still facing the European economy?

Warren: I mean, the loan guarantees, it definitely does not. Basically, that's just a pledge to roll debt. So that clearly does not effect the solvency issues, as some people call them.

But printing money... also it's more of a tactic than a solution. But what it would do potentially is if you put more money into the system, and investors are then forced into more risk assets, the global economy is already expanding. It would kind of give... If asset prices were robust, it would give those economies a better chance to participate in the global recovery, as opposed to a downward spiral of asset prices.

Glaser: Before the last financial crisis there was a lot of talk about the developing market decoupling from the developed world, that there could be a recession in the United States, but it wouldn't impact the rest of the world. Do you think that there could be a decoupling of Europe, that Asia and North America could continue to do well even if Europe continues to lag behind?

Warren: If it was just a lagging situation, then yes. But if we have a sovereign debt crisis and a full-blown banking crisis, which is one of the potential endgames here, in that situation absolutely not.

I think you have interlinked exposures between the banks and other financial institutions like insurance companies. So you have a lot of cross contamination there. You'd have dominos falling in terms of sovereign defaults, and likely bank and financial institution defaults. Once that happens, all the large global banks have counter party exposure to these banks, and asset prices would likely be in a tumble.

So, you'd have more difficulty accessing the capital markets across the globe, if it went that far. So I really do think it's important to put a firewall in. They tried to do that last weekend. In my opinion, it's one step short of what they needed to do.

Glaser: So investors in the United States should still be paying pretty close attention to the goings on of the ECB?

Warren: Yeah, I really think so. If it continues to get worse there, it will eventually become a problem here as well.

Glaser: And finally, given the sell-off, do you know think any of these banks look attractively priced or was the sell-off really for those fundamental reasons?

Warren: I think if you get to a stabilized situation, most definitely. So, the prices have come off sharply; they're below our fair values. The flip side is the uncertainty around our fair values is increasing just as quickly. We've raised some of our uncertainty ratings to reflect that.

But if you were able to stabilize the situation, some of the stronger banks in some of the stronger countries do start looking attractive. But you do need to have that confidence that the monetary authorities, the fiscal authorities take the right steps to really get a handle on this before it kind of gets out of control.

Glaser: Matt, thanks for your insight.

Warren: Sure thing.

Glaser: For Morningstar.com, I'm Jeremy Glaser.