Will Euro Debt Woes Hit U.S. Banks?

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Stocks were battered on Thursday as investors fretted about the economic recovery or lack thereof. But there was also concern about the European sovereign debt crisis. I'm here with Jim Leonard. He's a securities analyst for Morningstar, and we'll take a look at the crisis and see what impact it could have on U.S. banks and if there were any buying opportunities today.

Jim, thanks for taking the time today.

Jim Leonard: Thank you.

Glaser: So, let's take a look at the European sovereign debt crisis first. We've heard about a ton of bailouts coming from the EU to peripheral countries like Greece, Portugal, and Ireland. Have those not been successful. Have those not really staved off the crisis? Do you think the crisis is still there?

Leonard: Well, right now, the crisis seems to be spreading to Italy, and you need to understand that really Italy is the third-largest country in the eurozone. It's a massive economy. It is probably anywhere between 5 and 7 times the size of Greece and the rest of the smaller countries. So, what begins to happen is this Italian problem or their perceived possibility of an Italian problem, becomes almost uncontrollable by the European Central Bank. So those fears are starting to spread across Europe. Now it hasn't fully vetted in terms of that there is a crisis. But the possibility grows everyday, and that's really what we're seeing in the market.

Glaser: So that firewall they are trying to build around Greece appears to have potentially failed. So, what's the impact for the U.S. investor?

Leonard: Well really one of the things you want to look at especially on the financial side is that the smaller or let's say regional players really have almost no to very small exposure to Europe. So for them the direct effects will be almost nothing. Now you could say that we will see around the globe a slowdown and more of a recession; however, the midsized banks in the U.S. should be able to take that. They've increased their capital levels much greater than they were five years ago, and they are much more prepared for maybe a second recession, if it's a more lighter or sort of a flat economy going forward.

Glaser: So, if you're looking at some of the larger banks, such as the J.P. Morgans and the Citigroups of the world, are they much more exposed? Do they have a lot of exposure to European debt?

Leonard: They are at more exposed in terms of counterparty credit risk, and some of the larger commercial or regionals are a little more exposed. We've heard today that one of the larger regionals is out there looking not just at the counterparty risk, but the counterparty risk of their counterparties. So there are secondary effects, and everybody post-2008 started to look around the world and ask, "Who is the AIG of Europe? Who is the surprise that no one knows about?"

Right now, no one has found that. So, when you look at the large banks in the U.S., like the J.P. Morgans and the Citigroups, there is some concern. And if you have any concern about Europe you should not you should probably stay away from those. But I think it's fair to say that those companies nowadays are very sophisticated in their counterparty exposure and should be OK.

Glaser: So, perhaps its too early to ask this question, but what's kind of the end game in Europe. How do those countries contain this sovereign debt crisis? How do they get back to sort of a sustainable debt level and are able to kind of refocus on growth?

Leonard: Well, I think for Italy, it needs to prove that it can on an ongoing basis run a budget, let's say a flat budget in terms of expenses to revenues. The country not really proved that. Now, these last, let's say, 12 months have shown some hope in terms of Italy, but the country is still running at debt/gross domestic product ratio of about a 118%. So, Italy doesn't much room in terms of one more bad year.

So, from the good side, the country needs to continue to show everybody that it can stop its growth of debt to GDP. If that doesn't happen, we'll see this thing get out of control pretty quickly. The ECB will either have to come in and start buying Italy's debt or restructure the country, like it did in Greece.

Glaser: So, for investors who are seeing this big sell-off, and the big sell-off from financials as well, and they want to put some money to work, what are few names that you think are pretty insulated from this crisis and that have potential for good earnings growth over time?

Leonard: Well, like I said any of the larger or midsize regionals, such as PNC, U.S. Bank, or Wells Fargo, should be fine. But one of the things, I would like to caution investors is this is going to be a wild ride, especially in financials. I'd expect financials to be up and down a lot, and for inventors who can hold positions and understand what they are doing in terms of taking on a lot of volatility exposure, they should be fine.

Glaser: So, an iron stomach might be on order.

Leonard: Exactly.

Glaser: Jim, thank so much for your thoughts today.

Leonard: Thank you.

Glaser: For Morningstar, I am Jeremy Glaser.