The stock markets all rose Wednesday when Silvio Berlusconi agreed to resign as Italy's prime minister. That's because a lot of people think Berlusconi is the reason Italy is teetering on the edge of financial disaster. The markets are down today because those same people realized they were wrong.
The idea was that without Berlusconi, the Italian government will get its fiscal house in order and be able to pay back all the money it has borrowed. Italy depends on borrowed money to service its debt - which is significant, but not huge like that of either Greece or the U.S. In fact, the nation's fiscal deficits have actually been lower than what they were projected to be.
As the International Monetary Fund reports, the problem is a:
Mounting concern among investors about the two-way relationship between sovereign and financial risks, and about prospects for policymakers to craft a convincing and durable crisis resolution framework in the euro area. Without significant progress, there is a risk that market worries could become self-fulfilling, with consequences that could prove difficult to contain.
The fear is that the government can't deal with the deficit. More than anything else, that worry is driving up the cost of borrowing money to service the debt. Despite the news about Berlusconi, Italy 10-year bonds closed up yesterday at 6.7 percent. (That's because bond investors have figured out Silvio is a symptom of Italy's problems, not a cause.)The magic number here is 7 percent.When bond yields for Greece, Portugal and Ireland hit 7 percent, they all had to call on the European Central Bank and the IMF to bail them out. At midday Wednesday, Italy's 10 year bonds were at 7.68 percent and two-years were at 7.1.
Unlike those three nations, Italy has a huge economy. It is Europe's third largest, trailing only Germany and France. This has enabled it to borrow a lot of money from other people. As of March non-Italians held $1.1 trillion in Italian bonds. This is more than the combined total of foreign-held bonds for Ireland, Portugal, Greece. So even with the help of all the king's horses and all the king's men, the ECB and the IMF aren't going to be able to put Italy back together again.
How the U.S. is vulnerableThe Federal Reserve and U.S. banks have all been telling us they have very little direct exposure to European debt. Now what have I told you about believing anything the Fed and U.S. banks tell you? In this case, notice the reference to "direct" exposure.
While they do not own a lot of European bank debt, they do own a lot of European bank debt credit default swaps. As Bloomberg's Yalman Onaran so nicely put it:
U.S. banks increased sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish and Italian debt in the first half of 2011, boosting the risk of payouts in the event of defaults.
According to the Bank for International Settlement, guarantees provided by U.S. lenders on government, bank and corporate debt to those countries rose by $80.7 billion to $518 billion. Almost all of that was CDS. If Italy defaults - or even just looks like it is in danger of defaulting - institutions are going to want to make sure that the loan guarantors can pay off.
The actual balance sheets of most U.S. banks are scarier than anything Stephen King ever dreamed up. So when those calls come in ... well, you remember Lehman Brothers? Lehman is to this as a firecracker is to a stick of dynamite.
So that's why you should care about the prime minister of Italy. Sleep tight, now.