The United States and the European Union have each absorbed massive amounts of private-sector debt in attempts to contain their financial crises. The success of the U.S. effort, despite the debt ceiling wrangle and the sovereign downgrade it precipitated, contrasts sharply with Europe’s experience and provides important insights for fixed income and currency market participants.

This summer, the bruising political battle over the debt ceiling, and Standard & Poor’s subsequent decision to lower the United States’ sovereign rating, displayed some of the unanticipated consequences of the government’s policy responses to the Great Recession. But its assumption and/or guarantee of hundreds of billions of dollars worth of financial-sector obligations did allow most U.S. banks to offload troubled assets, secure liquidity, recapitalize balance sheets and return to profitability.

This contrasts sharply with the scenario playing out in the European Union (EU), particularly in its southern periphery. Three years after the U.S. financial nadir, the EU is still struggling to engineer a credible package of private-to-public debt shifts and backstops, in its attempt to avoid the uncontrolled default of some of its weakest and most indebted members, notably Greece, Italy and Spain.

In the United States, the private-to-public shift occurred relatively decisively, despite political grumblings. The Federal Reserve’s various emergency lending facilities, the government-backed shotgun marriages of Bear Stearns, Wachovia, Merrill Lynch and Washington Mutual, and the $700 billion Troubled Asset Relief Program (TARP) avoided more Lehman-like catastrophes and inflated asset prices enough to allow U.S. banks to recapitalize, while government support of the money fund and commercial paper markets kept them from collapsing.

The U.S. interbank and wholesale borrowing markets are now back in business. And, despite some market trepidation regarding the potential effects on bank earnings and stock multiples from the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Basel III capital accord, most U.S. financial institutions have been able to boost their equity and repair their balance sheets.

This type of private-to-public debt shift has yet to happen at the scale necessary in Europe for the region’s troubled banks to regain their footing. Since most of the banks are guaranteed, tacitly or not, by their governments, and peripheral countries such as Ireland, Portugal, Greece and Spain are suffering from massive debts and deteriorating economies, the only public entity capable of assuming the debt is the EU itself. But the temporary €750 billion European Financial Stability Facility (EFSF) established in May 2010 to provide emergency backstops for sovereign issues has not proven large enough to deal with all the troubled countries that need it. "The EFSF was meant to scare speculators off; the EU hoped never to use it," says Steven Major, global head of fixed income research at HSBC Bank plc. "But the market saw it as a red flag."

Sovereign appeal "In Europe, most of the strains are due to the market testing the willingness of politicians to accept that debt shift," says Michael Story, London-based economist and product specialist at Western Asset Management Company (WAMCO). "If the EFSF had been expanded to €2 trillion, or there was a full fiscal union, there wouldn’t be these strains in the periphery now."

The EFSF will be replaced by a permanent facility, the European Stabilization Mechanism (ESM) in mid-2013. Early work on the EFSF suggested it needed to be €1.5 to 2 trillion to appear credible to the market, Story says, but the political will for such a fund was lacking. Backstopping Ireland, Portugal and Greece has already used more than half the fund’s capacity, and problems in Spain and Italy would require more than the roughly €300 billion left. Ad-hoc measures are filling the gap, for the time being. These include large European Central Bank purchases of Italian and Spanish debt on August 8, 2011, which, in conjunction with ongoing interventions by the Spanish and Italian central banks, managed to drag their 10-year yields under the six percent level, above which they had been trading. Analysts believe a seven percent yield would be unsustainable. Despite this, the EU’s lack of fiscal union, worries about core countries’ willingness to support the periphery, and the fact that those peripheral countries do not control their own currencies and are therefore subject to credit risk remain substantial worries for lenders. They also highlight the reasons the U.S. private-to-public shift has been a qualified success, while European efforts have not yet borne fruit.

"Truly sovereign countries like the U.S., the U.K. and Japan have their own currencies. There is no measurable credit risk," says HSBC’s Major. "But where you don’t have control over your currency, it’s a different matter." This is the problem in the EU. Without control over their currencies, individual countries could, indeed, default. That is why the peripheral EU countries have seen their costs of funds rise sharply, while the 10-year U.S. Treasury Note was largely unfazed, even during possible talk of default during the debt ceiling brinkmanship. Nonetheless, few market participants remain willing to consider U.S. debt truly "risk-free."

The situation is analogous to a bank run. In the United States, the market has confidence in the "deposit insurance," meaning the credibility of the government’s backstop, and therefore doesn’t feel the need to demand more return to compensate for default risk. In Europe, the deposit insurance – in this scenario, the bailout funds – are not seen as large enough to be credible, so lenders demand to be paid for credit risk.

This led to a self-fulfilling dynamic in July 2011. "Higher yields hurt the peripheral economies, which in turn justified the higher yields," WAMCO’s Story says. This puts policymakers in a bind. Wanting to regain the market’s confidence, the EU issued a statement on July 21, 2011, reiterating its member countries’ commitment to three percent deficit ceilings by 2013. But the government cutbacks and austerity programs necessary to achieve that goal could hurt their economies, lowering growth rates and, in turn, making debt servicing more burdensome.

When deciding just how burdensome, some analysts use the heuristic ratio of public debt to gross domestic product (GDP). This can be misleading. What HSBC’s Major calls "true sovereigns" can support much higher debt-to-GDP than other countries. Japan’s public debt in 2010 was more than 150 percent of its GDP — the world’s highest — yet few worried about its solvency. Greece and Italy, on the other hand, rank fifth and eighth, with 144 and 188 percent, respectively.

Flight to Quality

All this has been a boon for the U.S. dollar, despite ultra-low interest rates. Indeed, despite the uncertainty caused by the U.S. downgrade, the debt ceiling battle and the poor economic indicators released in late July, the dollar has held its own. "At the height of the crisis, there was a flight into Treasuries," says Derek Sammann, managing director, FX and interest rate products at CME Group. "People were buying dollar-based assets, so they needed dollars."

The dollar and U.S. interest rates are benefitting from the government’s decisive moves to recapitalize its financial sector in 2008 and 2009, and from its safe-haven status, just as Europe’s lack of market credibility and cumbersome decision-making process have hurt the euro. Nonetheless, the uncertainty introduced by weak economic indicators in the United States and the unknown fate of Europe’s emergency measures, combined with the growth of public debt globally to around $50 trillion, has made careful hedging a top priority.