AP spells out EURO doom

The unthinkable suddenly looks possible.

Bankers, governments and investors are preparing for Greece to stop using the euro as its currency, a move that could spread turmoil throughout the global financial system.

The worst case envisions governments defaulting on their debts, a run on European banks and a worldwide credit crunch reminiscent of the financial crisis in the fall of 2008...

ACT I

What would Greece's exit look like? In the worst case, it starts off messy.

The government resurrects the drachma, the currency Greece used before the euro, and says each drachma equals one euro. But currency markets would treat it differently. Banks' foreign-exchange experts expect the drachma would plunge to half the value of the euro soon after its debut.

For Greeks, that would likely mean surging inflation - 35 percent in the first year, according to some estimates. The country is a net importer and would have to pay more for oil, medical equipment and anything else it imports.

Greece's government and banks currently survive on international loans, and if it dropped the euro, the country would probably be locked out of lending markets, says Athanasios Vamvakidis, foreign-exchange strategist at Bank of America-Merrill Lynch in London. So the Greek central bank would need to print more drachmas to make up for what it could no longer borrow from abroad.

That's one reason analysts say the switch to a drachma would lead the country to default on its government debt, possibly triggering losses for the European Central Bank and other international lenders...

ACT II

Here's where things get scary.

The European Central Bank and European Union would have to persuade investors in government bonds that they will keep Portugal, Spain and Italy from following Greece out the door. Otherwise, borrowing costs for those countries would shoot higher.

The main way European leaders have tried to calm bond markets is by lending to weaker governments from two bailout funds. Experts say these two funds, designed as a financial firewall to stop the crisis from spreading, need more firepower.

Much of the (EURO)248 billion ($310 billion) left in one of them, the European Financial Stability Facility, was pledged by the same countries that may wind up needing it, Vamvakidis says.

There's also a (EURO)500 billion European Stability Mechanism that's supposed to be up and running next month, but Germany has yet to sign off on it.

"If they fail to reassure bond investors, all of the nightmare scenarios come into play," says Robert Shapiro, a former U.S. undersecretary of commerce in the Clinton administration.

The biggest danger is a fast-spreading crisis known in financial circles as contagion - a term borrowed from medicine and familiar to anyone who has watched a disaster movie about killer viruses on the loose.

"It's like a disease that spreads on contact," says Mark Blythe, professor of international political economy at Brown University....

ACT III

A full-blown crisis would cross the Atlantic through the dense web of contracts, loans and other financial transactions that tie European banks to those in the U.S., experts say.

Blythe, the professor at Brown, believes credit default swaps, the complex financial instruments made infamous by the 2008 financial crisis, would provide the path.

Banks created the swaps to sell as insurance for loans. After lending money to a business or government, investors can turn to a bank and take out protection on the amount they lent. If the borrower runs into trouble and can't pay - say, the government of Spain defaults - the banks that sold the insurance cover the loss.

A $2 billion trading loss that JPMorgan Chase revealed in May, traced to a hedge against the Europe crisis, shows just how easy it is for even the safest and savviest of banks to slip up.

And it doesn't even take a default for a credit default swap to go bad.

If traders think other countries will follow Greece, they'll drive up borrowing rates by selling government bonds, which also pushes up the cost of insuring their debt. That's similar to how your neighborhood insurance agent handles a teenage driver.

In the derivatives market, where credit default swaps are traded, there's a twist. When markets treat Spain like a bad credit risk, those who took out insurance on Spanish debt to protect against a default can force the banks that sold the insurance to prove they can make good on the claim.

To do that, banks cash out something else - U.S. government debt, gold, or anything easy to sell. In normal times, it's no big deal. In a crisis, it can lead to a cascade of selling, spreading trouble from one market to another.

Another problem: It's not clear how much U.S. banks have at risk to Europe through credit default swaps because regulations let banks keep that information a secret.

"You could have American banks up to their necks in CDS liabilities," Blythe says. "We don't even know."...

However the Greek story ends, Blythe believes it's bound to be ugly. Putting 17 countries together to share a common currency worked well when Europe prospered. Now that they're struggling, "all the design flaws are becoming apparent," he says. And every solution that's supposed to fix a problem creates another problem.

The proposed $125 billion loan to save Spanish banks, for instance, will add to the debt burden of Spain. That sent Spain's borrowing costs higher this week and will put a tighter squeeze on its budget.

"The euro itself," Blythe says, "is a bloody doomsday machine."