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Possible Italian Bailout Moves Markets

July 11, 2011 | About:
The Daily Reckoning

The Daily Reckoning

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It’s one of those “risk off” days, in the parlance of the Street.

European leaders are meeting to discuss whether Italy will soon need a bailout – shocking traders who thought the whole euro mess was fixed when Greece secured its second bailout a few days ago.

The Dow, which crested 12,700 on Thursday, will be lucky to finish today above 12,500. The S&P is down more than 1.5%.

Hot money is fleeing the euro – which clings to $1.40 as we write – for the greenback. The dollar index is back above 76 for the first time since May.

Measured in the Esperanto currency, gold set a record today of 1,108 euros. It also set a record in the U.K. – 978 pounds.

Measured in dollars, gold has been all over the place today, the spot price spiking to $1,556 before settling back to where it was at the end of last week, around $1,547.

So why Italy… and why now? There appears to be a rift between the prime minister and the finance minister over how to pursue budget cuts and tax increases. Suddenly, the yield on a 10-year Italian government bond has blown out to 5.5% – twice that of the benchmark German rate.

Over the weekend, the German newspaper Die Welt quoted a source from the European Central Bank as saying the ECB’s bailout fund isn’t big enough to rescue Italy. “It was never designed for that,” he said.

Uh-oh.

If Italy defaults, it would trigger an even bigger crisis than the landslide traders have been expecting following a Greek default. As with Greece, the real danger lies with the credit default swaps held by European banks – a type of insurance policy they took out “just in case.”

In many cases, U.S. banks wrote those policies. And that’s what has everyone so nervous. Lehman Bros. took out a whole bunch of credit default swaps with AIG in 2008, which AIG couldn’t make good. We know how that one ended.

Now…check out this graphic representation of the Italian crisis’s potential magnitude:

Recipe2008Redux.gif

The left scale shows how much exists in outstanding credit default swaps.

The bottom scale shows each country’s debt-to-GDP ratio. Obviously, Greece is farther along on the road to bankruptcy. But Italy’s in second place… and it has a whale of a lot more debt the banks are insuring.

And it’s worth revisiting this point: About half of U.S. money market fund assets are invested in the very European banks that are up to their eyeballs in Greek and Italian government bonds.

This too has shades of 2008… when the Reserve Primary Fund “broke the buck” because it was sitting on a boatload of Lehman paper. Ponder for a moment what might happen if Italy defaults… the European banks hit up the U.S. banks for their CDS… and the U.S. banks can’t pay.

Do the U.S. banks turn to Uncle Sam for another bailout?

The first round of bailouts teed off everyone with a pulse – except for a few goofy economists and a host of bank employees – and happened when the national debt was $9.6 trillion.

Less than three years later, it’s now $14.3 trillion – a 49% increase. Thanks guys.

Imagine for a moment the sovereign debt crisis unfolds anew on or near Aug. 2, 2011, when the White House and Congress still haven’t hammered out a deal on the debt ceiling.

What do you get then?

You get the scenario we laid out in this forecast. If you haven’t connected the dots yet, we recommend you take the time to do so now.

The troubling fact is Italy and Greece don’t have to default to cause Uncle Sam a serious rash. Consider this small fact pointed out to us by publisher Joe Schriefer this morning:

According to this report by the Bipartisan Policy Center, just over $500 billion in U.S. Treasuries mature in August 2011. (If you’d like, you can read the entire report right here. But for quick reference, just check out the chart on Page 33.)

To “roll over” that debt, the Treasury must auction new debt in its place. They’ll use the proceeds of the new debt auction to pay off the old debt.

To add insult to injury, that $500 billion rollover is on top of an August deficit of roughly $150 billion (Page 12 of the report.) Assuming, of course, that the debt ceiling gets raised, the U.S. government will then have to issue $650 billion worth of new debt in August alone. By comparison, that’s more debt than the entire QE2 debt-buying campaign… in one month… without the Feds as the backdrop to buy the debt.

Beyond August, it doesn’t get better.

According to a separate report from the United States Government Accountability Office, just over $3 trillion of debt matures during the next four years.

http://www.treasurydirect.gov/govt/reports/pd/feddebt/feddebt_ann2010.pdf

Somehow, someway, the Treasury will have to find a way to roll over at least this amount plus any additional spending. What happens when that much debt is issued… without the Federal Reserve standing by with its checkbook?

The Bipartisan report explains that “Treasury will have to pay higher interest rates to attract new buyers… [or] it is possible, if unlikely, that not enough bidders would appear.”

The latter scenario means a government default.

For you, it’s just important to know that this is all part of what we’re dubbing the “Great American Lifestyle Reset” – the day that you won’t be able to count of the government to pay your bills… to keep you safe… or to provide you with medication in your golden years.

Addison Wiggin

for The Daily Reckoning

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