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European Crisis Slams Stocks as Investors Fear Greek Default


The collapse of the European Union as we know it is picking up steam and the impact is destroying US stocks.

The problem stems from the unpleasant fact that Greek government debt is worthless, and no turnaround is in sight. No one, not even the European banks themselves, know just how much of this Greek government scrip is in the EU banking system. Greece is merely Patient Zero in a European, if not global financial Black Plague. Speculation is now focusing on a Greek default as soon as this weekend.

This crisis has been staring the world in the face for months, if not years. Breakout hasn't been alone in trying to bring this to investors' attention, particularly as the situation began escalating earlier this week. Everyone knew the day of reckoning for the EU would come; the question was simply when the uncertainty would really start hitting the global equity markets.

The new information exacerbating today's European and U.S. market sell-offs is the resignation of European Central Bank official Jeurgen Stark for "personal reasons," widely believed to be Mr. Stark's personal objection to an ECB balance sheet expansion through a bond purchase program.

For its part, Greece announced this afternoon that it "rejects the talk of default." In a different context, Greece's announcement is adorable; akin to your kids rejecting the idea of bedtime. Given what's stake, it seems Greece remains in tragic denial.

Now that the process of pricing in of Europe's economic reality is now in full swing, it's simply a matter of figuring out the size of this thing. In an effort to get a sense of the magnitude, I asked Rob Arnott, founder and CEO of Research Affiliates, if the toxic debt crisis in the EU could rival that of the 2008 U.S. financial meltdown.

"This is bigger than Lehman in terms of scale," Arnott told me. "You're looking at most of the largest banks in Europe, which on a mark-to-market basis, are insolvent."

Mark-to-market is the process of finding a real price for an asset on your books. European banks have deferred recognizing that the Greek debt they hold is worth much less than what was paid for it. Avoiding this unpleasant dose of reality is why the European Central Bank is pushing to buy debt of the struggling (read: bankrupt) members of the EU at above market prices. The euphemism being used a Greek "debt restructuring." The reality is, it's a Greek debt default.

An ECB bailout for a struggling member requires the participation of healthy nations. With the largest and healthiest economy in Europe, German citizens are effectively being asked to bailout the PIIGS (Portugal, Italy, Ireland, Greece, Spain). Understandably, the Germans are refusing to pay for the fiscal sins of the Greeks. And, as Arnott notes, the charter which binds the EU "explicitly bans bailing one another out."

Germany, and other solvent nations, don't want to bail out the PIIGS and technically couldn't anyway. Unlike in the U.S. where TARP --secret loans and a bunch of fiscal duct tape-- held our financial system together during our financial meltdown, there is no real centralized authority in Europe. The EU is just a bunch of treaties, with terms that have been violated since inception by the same nations that are in urgent need of a bailout today.

Arnott says the best solution is for nations to "ring-fence" their banks to prevent systemic ripple effects. Doing so wouldn't avoid the dreaded mark-to-market, but it could contain the damage to individual nations (in theory, anyway). There is a case to be made that the ring-fence is too late and the contagion is already spreading. If that's the case and, by implication, a simultaneous rescue of every defaulting nation is required, Europe is out of luck.

"There's no pot of money on the planet big enough to bailout the entire Mediterranean rim," concludes Arnott. In other words, a global financial meltdown is slowly being priced back into the market.