The World Watches Europe

S&P’s warning of a downgrade to the credit ratings of 15 nations in the euro zone -- including six triple-A rated countries such as Germany and France -- will get worse if the European leaders don't hammer out and announce a grand plan by Friday’s big summit in Germany. The race is on -- they have three days now to save their ratings.

And as euro zone bond yields rise, the markets are telling euro zone officials that they need to act fast because the fate of the European Financial Stability Facility (EFSF), the zone’s rescue lending facility, rests on the six triple-A countries who back it—the loss of their top notch grade means borrowing costs for this rescue fund will rise, and market credibility is notoriously difficult to reverse. The EFSF has already lent money to Portugal, Ireland and Greece.

(On Tuesday morning, S&P placed the 'AAA' long-term credit rating of the EFSF on CreditWatch with negative implications.)

The threat of further downgrades come as a source close to the matter at the Federal Reserve denied a report in a German newspaper that the U.S. central bank planned to join 17 central banks in Europe to provide emergency funding to the International Monetary Fund for a rescue of countries in the euro zone. The U.S. Treasury also tells FOX Business there will be no U.S. funding of the IMF for this purpose.

Die Welt, the German newspaper, reported that euro zone officials want to ramp up by 50% the IMF’s emergency fund, now at $569 billion. The IMF’s purview has expanded since it made its first rescue loans in 1947, which relied on just one technique: an immediate currency swap, usually involving U.S. dollars. The IMF says it gradually expanded its “repertory” to at least ten lending facilities.

And here is the concern about IMF rescues. Ordinarily they carry a stigma, as borrowing countries must enact “a detailed program of macroeconomic and structural reforms,” says the IMF. The IMF usually ties aid to specific covenants like reforming pensions or public sector wages (something the U.S. government still doesn’t do).

An IMF rescue was thought to mean Europe would have to enact the IMF’s version of its fiscal austerity. The IMF also is first in line in getting paid back, ahead of all other investors.

However, the IMF in recent years has relaxed those standards, so Europe may be able to get IMF money and muddle through, slowing down reform and instead waiting on the bond markets to enact their fiscal austerity for them by demanding higher interest payments, or yields, on their sovereign debt.

The U.S. has funded about $55 billion of the IMF’s budget, the organization says. “After many years of failed attempts, the IMF has succeeded in setting up lending facilities that are more suitable for countries with good track records and solid commitments to implement good policies on their own,” it says.

However, an IMF rescue would provide a third party, go between that the euro zone seems to need right now, as its 17 member countries wrangle over a fix. The European central bank is also deep in debate over an unlimited guarantee for government bonds, among other ideas, difficult to do in the absence of a political union, much less a Eurobond,

Meanwhile, another red flag has cropped up. Euro zone banks have stuck increasing sums at the European Central Bank instead of lending that money out to other banks or to private sector borrowers. Worsening assets mean more capital set aside in reserves to back them up—banks are generally not lending either, because they also have to set aside more capital for them, more so in the face of tighter government rules on capital. Use of the ECB’s “deposit facility” rose to $421 billion a week ago, the most since June of 2010.

Meanwhile, euro zone leaders are working to fire proof their banks, as European banks are struggling to raise money in the capital markets as they face a bond buyers’ strike. In the financial crisis three years ago, the governments bailed out the banks, now governments need banks to buy their bonds.

Also, European bank funding from U.S. money market funds are drying up. Money markets provide short term, overnight loans to banks in the commercial paper market and have an estimated $2.6 trillion, with more than a third of sunk in the debt of European companies, says Fitch Ratings.

A number of Euro banks needing dollars may not have big American units to provide them, too.

Fitch Ratings reports that U.S. money market funds have slashed their short term loans to European banks by more than 40% in the past two quarters. Barclays Capital reports that European banks raised just $24 billion in unsecured bonds since the end of June, versus $161 billion in the same period a year earlier. That’s why the Federal Reserve announced it planned to increase dollar swaps to European banks via the ECB, in conjunction with other central banks.

European banks now trade at 30% to 40% of their book value, reports Wall Street analysts, meaning investors expect more write downs.

In the U.S., Nomura Securities reports that U.S. bank loan growth is at its fastest since 2008. That is in the face of the Federal Reserve keeping rates down at zero until 2013. To do that, the Fed has bought mortgage and government bonds to push their prices up and yields down. It has created out of thin air $1.5 trillion to buy those bonds off of bank balance sheets since late 2008.

As the Fed has taken over the yield curve, banks continue to struggle to make money off of loans. Better to park their money at the central bank and earn a quarter point on interest than risk it, is the thinking. Meanwhile, the U.S. economy struggles as savers have seen their deposit interest rates vanish, and don’t have the money earned in interest to spend. The biggest U.S. banks now have liquid assets triple or more than ten times their short term paper, reports Moody’s Investors Service.

As France’s Nicolas Sarkozy faces a tough re-election bid next spring, the spread of French bonds over German bunds have gapped to their  highest point since the Euro was launched. France reportedly has not balanced its budget since 1974. Italy has 65 million people and $2.6 trillion in debt—it faces a 0.5% cut in GDP growth next year, as it begins to roll over a fifth of its short term borrowings.

A break up of the euro zone is still not out of the question. If that would happen, stronger countries’ currencies would rise, making it difficult to export. For example, theoretically, Germany would go back to the deutsche mark, which would then rise in value against the currencies of weaker countries, making it likely harder for German manufacturers to export.

In Germany, taxpayers are still angry they are landed with the bill every time a southern euro zone country goes on a spending spree. Which is why Germany wants to uphold the Maastricht treaty’s rule on not having debt surpass certain percentages of GDP.

German leaders note that the euro zone's current budget rules have been violated more than five dozen times over the past decade by member nations, including Germany, without punishment. So enforce the limits of the stability pact is now the call, meaning, deficits not more than 3% of gross domestic product and no more than 60% of government debt to GDP.  Germany wants to haul violators before the European Court of Justice.

Even so, the lenders of last resort—or the buyers of government debt of last resort—is not penalizing them. The ECB, the Federal Reserve and other central bankers have kept borrowing rates at historically low levels, and indeed, have slashed the interest rate on emergency dollar swaps.

Will there be higher inflation, and what will eventually happen to long term interest rates? Kick that can down the road for now.

Meanwhile, the world has watched regime change in Portugal, Ireland, Italy, Greece and Spain, even Belgium. Whether these new leaders will do reform remains to be seen. Worth noting is the regime change in the debt crisis in Latin America three decades ago, including the military regimes of Brazil and Argentina, with both growing faster in ensuing decades.

Same for Russia and Mexico, which also defaulted in the ‘90s and enacted fiscal austerity. The same can largely be said of Malaysia, Laos, Thailand, the Philippines, South Korea, and Indonesia, which saw widespread government reforms in the 1997-98 Asian crisis.

Question: Does the Dodd-Frank financial reform bill provide a road map of how to take over and dismantle a large bank with large, European international operations?