Why Europe Matters to Financial Portfolios by WealthTrust-Arizona

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Wealth management financial expert at WealthTrust-Arizona explains the European debt crisis and why it matters to American investors.

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How is it possible for the financial problems of a country so small and so far away to create such turmoil in the world's markets?"

Ever since the Greek sovereign debt issue has become headline news, many people have found themselves wondering, "How is it possible for the financial problems of a country so small and so far away to create such turmoil in the world's markets?" What is happening in Europe is probably affecting financial portfolios right now, regardless of the quality of holdings or how well diversified people are. Don Bertrand, Vice President and Senior Financial Advisor at WealthTrust-Arizona, examines how certain activities in Europe could directly impact investors financial portfolio.

According to Bertrand, the PIIGS nations (Portugal, Italy, Ireland, Greece and Spain) are having difficulty coping with the debt created by years of deficit spending. A robust global economy helped to mask the problem, but in recent years the burden of sovereign debt - bonds issued by sovereign governments - has become increasingly unsustainable. One of the major concerns about the possibility of sovereign debt default has to do with the financial stability of banks that hold the debt. Some of the largest French banks have already suffered downgrades of their credit ratings because of their extensive holdings of debt from troubled European countries, particularly Greece.

According to Broadridge Investor Communication Solutions, American banks hold very little Greek debt compared to European banks; however, they could face a challenge from what are known as credit default swaps. “Investors with large bond holdings from a particular borrower often try to protect themselves against the possibility that the borrower will default by buying a credit default swap on that debt as a type of insurance,” explains Bertrand. “The company that issues the credit default swap agrees to cover the bondholder's losses in case of default. The riskier the issuer, the more likely bondholders will try to protect themselves with swaps. However, in some cases, a company may have issued so many default swaps on a particular issuer that it could be overwhelmed by the claims resulting from the issuer's default.”

Such derivatives can create a ripple effect in financial markets. If the company that issued the swaps cannot make good on them, the institutions that relied on that protection also can find themselves in trouble, which multiplies the impact of a major default. U.S. financial institutions are major issuers of credit default swaps, and the potential impact of a Greek default on them is unclear. However, since the 2008 financial crisis, U.S. banks have been forced to hold greater capital reserves to deal with contingencies, and Treasury Secretary Timothy Geithner recently said that banks here have reduced their exposure to the debt of troubled countries.

“Another thing to keep in mind is that lending worldwide has not fully recovered from the last financial crisis, and has helped keep the global economic recovery sluggish,” states Bertrand. “Fiscal austerity measures taken to try to reduce deficits have also taken their toll, hampering economic growth and making it even more difficult for countries such as Greece to balance their budgets. If banks' lending ability were impaired further by a financial crisis brought on by a default on sovereign debt, tighter credit could increase the odds of renewed recession.”

Europe represents a major market for many American companies, and a recession there would not help an already-slowing global economy. "Even though Greece is the immediate concern, larger economies like Italy and Spain actually could represent a bigger threat. If either country were to decide it needed to restructure its debts as Greece is attempting to do, that would have a much bigger impact than Greece,” warns Bertrand.

To compound the problem, borrowing costs for both Italy and Spain have risen. Nervous investors have been demanding higher interest rates to compensate them for the higher perceived risk of buying that sovereign debt. “As any credit card holder knows, having to pay a higher interest rate makes paying off debt much more difficult,” explains Bertrand. “A Greek default could make investors even more nervous about buying other troubled countries' debt, and being frozen out of credit markets would likely aggravate fiscal problems abroad.”

Keep in mind that uncertainty in Europe could persist for months, but it is important to keep it in perspective. “You should definitely monitor what is going on in Europe, however, do not let every twist and turn derail a carefully constructed investment game plan,” advised Bertrand.


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