What could happen to the U.S. if Spain defaults?

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(MoneyWatch) U.S. Treasury Secretary Tim Geithner has repeatedly said American banks are at low risk from the overseas debt crisis because they have little direct financial exposure to Europe. That means they haven't been making loans straight to European borrowers. There is no reason not to believe him.

Unfortunately, the problem here is the indirect exposure. U.S. banks have made loans to institutions that have made loans to EU nations, including Spain. They almost certainly provided loan insurance -- known as credit default swaps (CDS) -- to these institutions as well. Or they may have made these loans and CDS to institutions which made the loans and CDS to EU nations, including Spain.

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If Spain defaults, two things would likely happen. First, many banks will have to account for these now worthless loans. Anyone who loaned money to those banks will want to know if their loans will be repaid. If they can't, then they will either have worthless loans of their own to deal with or, if they bought insurance, they will cash in their CDS. This will ripple out to other banks and companies just as it did when Lehman Brotners collapsed in 2008. However, this will likely be on a much, much larger scale. Economists call this collateral damage "contagion."

If U.S. financial institutions are in as good condition as we have been told, then they will pay out a lot of money. That will mean they have less money to lend to American businesses. It is already difficult for these businesses to get all the funds they need.

If these institutions are in worse condition than they have let on -- and it is possible some of them are -- then they would be at great risk of going out of business. (Because of the Federal Deposit Insurance Corp., most depositors would still get all of their money back if that happened.) Either case would severely damage the American economy, which would also be dealing with a large drop in demand for goods and services. We would certainly be in a recession, or possibly something worse.

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    Constantine von Hoffman is a freelance writer and writing coach. His work has appeared in outlets such as Harvard Business Review, NPR, Sierra magazine, Brandweek, CIO, The Boston Herald, TheStreet.com, CSO, and Boston Magazine.

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