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Thursday, 2 October 2008

The U.S. Financial Crisis Is Spreading to Europe

by Mark Landler

Barely a week after Europeans rebuffed American pleas to join in their bailout of the banking system, Europe now faces a financial crisis almost as grave as that in the United States -- demonstrating how swiftly this contagion is spreading around the world.

In the last two days, governments from London to Berlin have seized or bailed out five faltering banks. In Ireland, where rumors of panicked withdrawals from banks spooked the stock market, the government has offered a two-year blanket guarantee on all deposits and bank debt.

Asia has been less buffeted by the turmoil, though a brief run on a bank in Hong Kong last week brought back dark memories of June 1997, when speculation against the Thai currency sparked a financial crisis that fanned rapidly across Asia, and later to Brazil and Russia.

Economists see a parallel between these two crises a decade apart: once creditors panic and begin to pull out their holdings, the underlying health of banks -- or entire countries -- no longer matters a great deal. In a global financial system, national borders are porous.

"In this day and age, a bank run spreads around the world, not around the block," said Thomas Mayer, the chief European economist at Deutsche Bank. "Once a bank run is under way, it doesn't matter anymore if you have good loans or bad loans. People lose confidence in you."

In a sign of how vulnerable Russia remains to contagion, officials halted trading on the Moscow stock exchange for two hours on Tuesday morning, fearing investor reaction to the House's rejection of the Bush administration's bailout plan. Trading resumed, and after President Bush vowed to win approval of the package, shares bounced back.

"People ask, 'What on earth is happening with Russia?' " said Roland Nash, chief analyst at Renaissance Bank in Moscow. "Russia is reacting to the unprecedented size, complexity and danger coming out of the U.S."

The shock waves could reverberate to the United States, experts said, since Russia has plowed its oil wealth into American debt, including Fannie Mae's. Russia has additional problems, including unstable oil prices and a newly assertive foreign policy that is unpopular with many investors.

The trigger for the loss of confidence in Europe, Mr. Mayer and other experts said, was the Treasury Department's decision two weeks ago to let Lehman Brothers fail. That ricocheted through European markets, hurting banks and retail investors with exposure to Lehman.

It took a few days longer for Europeans to digest the implications of the collapse. But now that they have, they are turning a remorseless eye on other institutions they suspect of being vulnerable.

As the White House scrambles to retool its rescue plan for the financial system, the global creep of the crisis has far-reaching implications, administration officials and outside experts said.

It is likely to move Europeans to mount a more coordinated effort to shore up banks, a move that the Treasury secretary, Henry M. Paulson Jr., pleaded for last week. President Nicolas Sarkozy of France is calling for a minisummit of leaders in Paris on Friday.

"We all agree that the method by which everyone comes up with ad hoc solutions in his corner the moment a crisis starts in a financial company isn't a systematic enough method," said Prime Minister Jean-Claude Juncker of Luxembourg, chairman of a group of European finance officials.

On Tuesday, France and Belgium threw a $9 billion lifeline to Dexia, a Belgian-French lender -- a day after Belgium, the Netherlands, and Luxembourg cobbled together $16.2 billion to rescue another bank, Fortis.

Europe's woes could place additional burdens on an American plan, as more banks fall into distress. If the Treasury wins Congressional approval to buy mortgage-related securities from banks, how it prices those assets will affect the solvency of European institutions.

Some of these banks suffer a form of guilt by association by being in the home lending business. Others, like Fortis, lack a strong base of deposits, which acts as a buffer against credit-related jitters.

Countries that suffered housing bubbles -- like Ireland, Britain and Spain -- are especially vulnerable, as are several Eastern European countries and other emerging markets, which are running steep current account deficits and low foreign currency reserves.

Ireland's finance minister, Brian Lenihan, traced his country's predicament back to Lehman Brothers, saying that the American authorities "were mistaken in permitting that bank to go to the wall because it has had very serious consequences for the world financial system."

The Irish plan guarantees bank deposits and debt for customers and creditors of six banks. That makes the government responsible for $400 billion, twice the country's economic output.

Experts predict a rash of bank failures in Europe, though some say the process may prove less politically fraught than in the United States, given the tradition of nationalization there.

So far, the hurdle to a broader plan has been the European Union's legal and political restrictions that require burden-sharing and consensus. "The Europeans are more rigid and rule-based than the Americans," said Simon Johnson, a former chief economist at the International Monetary Fund. "But when things get bad enough, they'll find the flexibility."

One red flag, he said, is UBS, the giant Swiss bank that is heavily exposed to mortgage-related securities and is headquartered in a small country that is not a member of the union. "Opinion is divided as to whether Switzerland could bail out UBS," Mr. Johnson said.

Beyond individual banks, the United States has to worry about the health of major holders of American government debt, from Russia and China to oil-producing states in the Middle East.

Russia is a particular concern, experts said. With oil prices swooning and its own banks in crisis, it is coming under financial strain. If the Russians were to sell off their American debt holdings, it could depress the dollar and multiply the cost of a bailout.

Russia has already begun whittling its vast foreign reserves to finance an aid program for its banks. American officials said shifts in foreign holdings of American debt were not great.

Other big creditors, like China, are in better shape financially, according to experts. But even there, growth is slowing, as trans-Pacific trade dries up. Should that contraction be traumatic and cause a banking crisis, it could lead the Chinese to sell their American holdings, these experts say.

The dollar has also remained remarkably stable, given the turmoil on Wall Street and in Washington -- another sign, economists said, that foreign investors have not yet lost faith in the United States. Partly, though, that reflects a paucity of other safe places to invest money.

"We would run into a huge problem if foreigners lost confidence," said Kenneth S. Rogoff, an economist at Harvard. "The rest of the world will give us several swings at the ball before they give up on us."

Carter Dougherty contributed reporting from Frankfurt and Andrew Kramer from Moscow.

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