Banks Face Crisis Of Confidence, As Europe Falls Further [LIVE UPDATES]

The crisis in Europe showed no sign of letting up on Wednesday, and analysts and observers warned of the potential for a sharp financial downturn overseas. Hours after the markets closed in Europe, the credit ratings agency Fitch Ratings downgraded five major European banks and banking groups: Credit Agricole in France, Rabobank Group in the Netherlands, Danske Bank in Denmark, OP Pohjola Group in Finland, and Banque Federative du Credit Mutuel in France.

While U.S. banks were unscathed, they now face a possible crisis of confidence. Many dumped risky European debt and other assets earlier this year, but banks in the U.S. are still at risk in the face of a recession and credit crunch in Europe. In a report last month, Fitch called the outlook for U.S. banks "stable" at the end of the third quarter, but warned that the spread of debt problems in Europe would have "sizable" effect because of the connectivity of global banking firms.

Earlier on Wednesday the euro plunged to below $1.30, an 11-month low; Italian government bond yields traded above 7 percent, the level widely considered unsustainable, and stock markets in the United States and Europe fell. The FTSE Eurofirst 300 fell 2.25 percent, the CAC 40 in France plunged 3.33 percent, the DAX fell 1.72 percent and the S&P 500 fell 1.13 percent.

"Europe is on the cusp of a recession: one that will be mild at best," said Michael Gregory, senior economist at BMO Capital Markets.

For more than a year, U.S. banks have been reducing their direct exposure to Europe, particularly its most stressed countries -- net exposure to bad debt in Portugal, Italy, Ireland, Greece and Spain by the six largest U.S. banks represented only 0.5 percent of total assets at the six largest U.S. banks, according to the Fitch report. However, banks have substantially more assets tied to France, Germany and the United Kingdom, according to this report.

Banks do hedge their bets on Europe, buying insurance essentially against falling assets. Goldman Sachs reported in an earnings call in September that its exposure to Portugal, Italy, Ireland, Greece and Spain was net $2.5 billion after hedges, for example. However, whether or not those hedges will actually work in the event of a government default is an open question. Voluntary debt forgiveness, which has already happened in Greece, is not covered under these hedges, notes the Fitch report.

No matter the direct amount of assets U.S. banks have in Europe, the risks of a 2008-style credit crunch loom in such an interconnected economy.

"If we were to get a series of failures in Europe, [it would be] hard to avoid a seizing up of markets as everyone pulls back and avoids risk," said Martin Baily, an economist at Brookings Institution and former chairman of the council of economic advisers under President Bill Clinton.

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