EURO PAIN COULD BLOW BACK ON BIG U.S. BANKS / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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MAY 14, 2010, 4:35 P.M. ET.

Euro Pain Could Blow Back on Big U.S. Banks .

By DAVID REILLY

Federal Reserve officials took pains this week to dispel any notion that their support of Europe's $1 trillion bailout meant U.S. taxpayer funds would be used to prop up the profligate Greeks. But in explaining the need for it to help ease financial strain, the Fed underscored that big U.S. banks remain vulnerable to Europe's financial contagion.

During a closed-door meeting on Capitol Hill, Fed Chairman Ben Bernanke told lawmakers a European crisis would threaten U.S. banks, Sen. Richard Shelby said after the meeting. In a speech Thursday, Fed Vice Chairman Donald Kohn noted that lending systems "remain somewhat vulnerable."

Yet big U.S. banks reported minimal exposures to Greece or Portugal, the most at-risk countries. So where does the danger lie?

The biggest threat is that the European rescue operation proves insufficient and problems spread from smaller euro-zone countries to bigger economies like France or Germany. That may threaten the viability of the euro, potentially paralyzing credit markets globally, just as happened following the collapse of Lehman Brothers.

If so, this could spell big trouble for five of the biggest U.S. banks—J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. Exposures to France and Germany, along with second-tier euro countries, is equal to about 81% of the banks' combined Tier 1 common capital, a buffer to absorb losses, according to first-quarter and year-end securities filings.

While the risk of widespread contagion is still a worst-case scenario, fears that Europe's debt crisis is far from over and that austerity measures may slow economic growth roiled stock markets Friday and pushed the euro to 19-month lows.

Which countries should investors in U.S. banks worry about? Take Ireland, Spain and Italy. Exposures of the big-five to these three are equal to about 25% of the banks' combined Tier 1 common capital. In particular, U.S. banks have to worry about banks in these countries being hit. Exposure to banks in Spain and Ireland, for example, exceeds risks to government or private entities.

An even bigger risk is if any European crisis blows back on the bulwarks of the euro: France and Germany. It's not impossible for that to happen. French and German banks have Greek exposure of more than €110 billion ($138 billion). Analysts have predicted that any restructuring of Greek debt could force France and Germany to recapitalize some of their own banks.

The big U.S. banks had exposures to the debt of governments, banks and other entities within those two countries equal to about 61% of their combined Tier 1 common capital. Exposure of the big-five banks to French and German counterparts totals about $100 billion. And while German government bonds likely would be a haven, the U.S. banks' exposure to German banks is greater than their government exposure.

Clearly, holdings of European bank and government debt wouldn't be worthless, but the financial crisis showed how quickly bank fears can feed on themselves. And the need for the Fed to help backstop Europe raises the question of whether, nearly two years after the crisis, U.S. banks really have enough capital, and liquidity, to weather big global shocks.

Investors in U.S. banks should be on alert: What happens in Europe may not stay there.

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