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On Friday, the cost of insuring against default by European banks through credit default swaps rose to the highest level since the aftermath of the Lehman Brothers collapse.  Certainly, it is never (well, hardly ever) a good sign when something can be compared to post-Lehman levels, particulary when that something is the cost to insure against bank default.  Essentially, it now costs over $280,000 to insure $10M worth of bonds annually for five years for the 25 largest banks in Europe.  The cause?  The Greek debt crisis.  Here is my understanding of why this is occuring and what it tells us about the market:

1) Politics: The EU/IMF bailout package is dependent on Greece implementing harsh austerity measures, measures that are (rather predictably) unpopular with citizens.  Greeks have demonstrated their displeasure through a number of protests–some resulting in violence.  Any sort of fiscal restraint and budgetary austerity comes down to politics–will the government have the political will to endure the serious protests of their constituents.  The price of insurance for banks with heavy exposure to Greece is signalling that the market thinks the political risk here is significant and likely to lead to default.

2) Contagion: As a result of political instability, the dire status of the Greek economy, and the significant exposure to Greece’s debt of European banks and other troubled economies (the so called PIIGS), investors are signalling their lack of confidence that many of the largest European banks would be able to weather a cascade of sovereign defaults.  Given how interconnected the debt of the PIIGS are (great graphic here) and the overall weakness of their economies, the market seems to assume that we will see not simply a Greek default, but potentially a number of concurrent defaults.  Those banks with significant exposure to Greece and the other economies will be in a position to lose big time.  The spreads are an indication of how worried the market is that these banks are either overexposed or will be the victims of runs similar to what we saw in the US post-Lehman.

In either case, the simple fact that the cost to insure against these banks defaulting has spiked in this fashion is very worrisome, to say the least.

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