WASHINGTON – Investors are dumping Spanish, Italian, even German bonds four days before a Greek election. The election results potentially could trigger financial panic not just across Europe but around the world — a process called "contagion." Investors are also skeptical about a plan to save Spain's troubled banks.
Here's a look at the issues:
THE BIG FEAR: Investors are concerned that Greeks will elect a government that will reject the terms of a $170 billion bailout. That bailout has required draconian budget cuts. If Greece dumps the agreement, it would probably default on its debts. And it would likely have to abandon the euro, the currency shared by 17 European countries. Greece's departure from the euro alliance would likely cause chaos. In part, that's because Greek debts, now denominated in sturdy euros, would instead be denominated in far shakier Greek drachmas. Banks, businesses and investors that hold Greek debt — and depositors with savings in Greek banks — would absorb huge losses in the transition.
COLLATERAL DAMAGE: If Greece drops the euro, other weak countries, like Portugal, might follow. The result would be further losses for lenders and depositors. Another fear: Stronger European countries, like Germany, would have to contribute heavily to European bailout funds to keep the eurozone from collapsing. Investors are worried that Germany's debt burden would rise as a result. That's why they're driving up the interest rate on super-safe German bonds.
WORST-CASE SCENARIO: What scares investors most is a repeat of what happened on Wall Street after Lehman Brothers collapsed in 2008: Banks would stop lending to each other. That could happen if banks worry about each other's solvency in light of losses on European debts. Major international banks are so interconnected that once they lose confidence in each other, fear spreads rapidly across the world. Once it does, investors tend to panic and send stock markets plunging.
SPANISH FLU: Over the weekend, eurozone finance ministers offered to lend Spain up to $125 billion to strengthen its banks. Those banks face huge losses on real estate loans. The bailout plan was supposed to reassure investors ahead of the Greek election. It didn't. Interest rates on Spanish government bonds continued to rise. That showed that investors lack confidence in the plan. They worry that the bailout loan increases the Spanish government's debt burden. Private investors who hold Spanish bonds also fear that if Spain can't fully pay its debts, they'll be the first to absorb losses. Priority would instead be given to repaying the official eurozone loan.
POSSIBLE SOLUTIONS: The European Commission has proposed a stronger version of deposit insurance. Individual countries now provide deposit insurance. But the fear is that national deposit insurance funds would be overwhelmed by a major banking crisis. So the commission has proposed a deposit insurance plan backed by the entire 27-country European Union. Policymakers are also weighing a plan under which the eurozone countries would jointly issue bonds and share responsibility for repayment. But Germany has resisted so-called "eurobonds."