Wednesday, November 9, 2011

Italy: A Financial Run in the Making

If you ever wanted to see what a bank run looks like, you can watch the 1946 film, It's a Wonderful Life, starring Jimmy Stewart, or you can watch Italy. Greece's deterioration in the past few weeks laid the foundation for Italy's distress. As Greece was sucked down the drain, Italy began wavering, and then wobbling. Now, yields on Italy's bonds are skyrocketing, exceeding 7%. That's the range bond yields for Greece, Ireland and Portugal reached before those nations went down the tubes. Italy isn't literally a bank, and holders of Italian bonds can't go to the counter and make a withdrawal. All they can do is sell in the secondary market for whatever price is available, and lots of them are.

Rumor has it that the ECB is buying Italian bonds in an effort to stabilize the situation. But that would be a temporary measure. The ECB by itself is a wee bazooka, unless it starts printing money and that's not allowed by its charter. The EU has already announced that it has no plans to bail out Italy. Indeed, its bailout fund, the EFSF, doesn't have enough money to bail out Italy. Nor does the IMF. Nor do the Chinese or the Brazilians. Eyes will inevitably turn toward America. But the political situation here precludes a fiscally funded bailout for Italy. And the Fed, which has no compunctions about printing money, can't print Euros. Its bazooka uses different ammo.

Italy is on its own, and Jimmy Stewart is no longer around to step in and calm things down. It's up to Italy to persuade the fixed income vigilantes that it can pay its debts as they fall due. That's a tall order in this time of Euro-skepticism.

Compared to Italy, Greece has a small amount of sovereign debt outstanding. Yet Greece's problems were enough to knock down a major European bank, Dexia, and a significant American brokerage firm, MF Global. If Italy's bonds maintain their downward trajectory, it's entirely possible that more financial firms will fail. Sadly, we don't have enough readily available information about the bond holdings, derivatives exposures and counterparty risks of financial institutions to easily predict which ones might be in trouble. That lack of information exacerbates the potential for systemic risk. Volatility reigns supreme in the financial markets.

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