Thursday’s stock market sell-off can be traced directly to a statement released by Fitch Ratings. In this statement, Fitch declared that the U.S. bank exposure to precarious European debt posed a “serious riskâ€Â. According to information gleaned from the Bank for International Settlement (BIS), as of the end of 2010, U.S. banks had a combined $41 billion in total expenditure to Greek debt alone. It is thought that much of this is in the form of credit default swaps.
A credit default swap (CDS) is a form of insurance contract that can be bought and sold to offset the risk of a default. The seller of a CDS is obligated to reimburse the buyer if the loan or security named in the CDS contract agreement goes into default. In the event of non-payment of the original loan, it is customary for the seller of the CDS to receive the defaulted loan after reimbursing the buyer of the CDS.
Assuming that Greece is forced into a “partial†default as outlined in the agreement reached late last month, European banks holding Greek debt will be forced to accept a 50 percent haircut. It is likely this will constitute a default and will force U.S. banks that sold CDS contracts to cover the losses.
French Banks on Credit Review
On Wednesday, Moody’s Investors Service turned the market’s attention to France after announcing that it was putting several French banks on review. Credit Agricole SA, Societe General SA, and BNP Paribas were all identified for potential credit rating downgrades due to their high level of exposure to Greek debt.
The Fitch Ratings statement, together with the Moody’s bank review notice, had nervous investors abandoning equities for the safety of the U.S. dollar. By mid-day trading in New York on Friday, the euro had fallen to $1.3520 from $1.3751 at the close of business on Monday.
