French Connection: Banking Woes Ripple Across Atlantic

France has the second-largest economy in Europe, behind budding superpower Germany. It was not supposed to wallow in the mud with the PIIGS.

Thats why speculation that France is being targeted for a credit downgrade have ricocheted through global marketplaces, stoking fears of an economic meltdown on a par with the financial crisis of 2008

Any threat to the French banking system would have severe ramifications in the U.S., analysts say, because French financial institutions are far more entrenched in the U.S. economy than banks headquartered in any of the so-called PIIGS nations: Portugal, Italy, Ireland, Greece or Spain.

Christian Moretti, an international banking attorney with New York law firm Venable LLP, said the U.S. exposure to France is much more relevant than to other troubled European economies because of the strong economic ties between the two countries.

The three major French banks Societe Generale, Credit Agricole and BNP Paribas are among the largest issuers of debt to U.S. money market funds. (According to Fitch Ratings, the ten largest U.S. money market funds have nearly half of their assets invested in securities issued by European banks.)

Shares in the big three French banks have tumbled this week as concerns have been raised over those banks exposure to sovereign debt issued by troubled European countries. Reuters reported on Thursday that an Asian bank has cut credit lines to major French lenders, and that five other Asian banks are reviewing trades and counterparty risk to French banks related to their exposure to PIIGS issued debt.

A downgrade of French credit would make a direct hit on those three big French banks and then ripple across the Atlantic Ocean. One aspect of the U.S. fallout would likely be significant withdrawals from money market funds with heavy exposure to those banks.

While the threat of an actual French downgrade seemed to ease late Thursday, the speculation itself poses its own form of threat to market stability, said Peter Crane, president of Crane Data, which tracks money market funds.

The real risk is that the headlines make investors nervous and they start selling and that the selling fabricates a run (on money market funds), said Crane.

In fact, the opposite has been true in recent days, Crane noted, as U.S. money market funds experienced sharp inflows in the past week. Indeed, U.S. money market mutual funds took in $61.3 billion in new cash last week, raising total assets in the funds to $2.59 trillion, according to research firm iMoneyNet.

The funds had taken a significant hit in July, as investors withdrew more than $100 billion while the threat of a government default hovered over the investment landscape.

At the same time U.S. investors were cautiously eyeing Washington, money market fund managers were cautiously eyeing Europe. Crane said fund managers, aware of the growing potential for contagion of the debt crisis, were gradually reducing their European exposure, shedding debt from Spain and Italy.

But they certainly havent abandoned the big French banks, according to Crane.

The obvious threat is that one of these banks might defaults, he said. But the odds of that happening are slim to none. They are, in effect, too big to fail in France. Certainly, as we saw with Lehman Brothers, it can happen. But its a once in a lifetime event.

The French banks have direct lines of credit to European Central Bank, he noted, and the ECB has swap facilities with the U.S. Federal Reserve if they need U.S. dollars. These banks have almost $1 trillion in reserve with the Fed, Crane said. Money market managers have said they are safe.

Specifically, whats spooked ratings firms and international investors alike is the French banks exposure -- or perceived exposure -- to sovereign debt issued by the PIIGS.

Its not surprising that they were placed under review by (ratings firm) Moodys, said Moretti, theyre exposure is staggering. The big three French banks are reportedly holding an estimated $50 billion of Greek debt and $393 billion of Italian debt, he said.

The impact of a French downgrade would also be felt on the European banking agencies charged with bailing out troubled Eurozone economies. Entities such as the European Financial Stabilization Mechanism and the European Financial Stability Facility require that contributors have the highest possible credit rating. Should France be downgraded it could no longer contribute to those bailout funds and other countries, notably Germany, would be left holding the bag. That wont go over well Germany, whose government is already reluctant to contribute to any further bailouts.

There has even been speculation the U.S. could be called upon to contribute to European bailouts if qualified Eurozone countries cant or wont cover the tab.

It will be far more expensive for the other countries to bail out Greece if France is downgraded, said Moretti.

Every effort will be made to avoid a downgrade of France, he added.

Chris Ciovacco, president of money management firm Ciovacco Capital Management, said a French downgrade poses a significant threat to the stability of financial markets, particularly in the U.S.

Being in the U.S. isnt going to insulate you from one of these downward spirals that starts in Europe, he said. Its gonna get everybody if there is (widespread) risk aversion.

Even so, Ciovacco said he doubts U.S. investors in money market mutual funds face much actual risk.

Money market funds will be backstopped and guaranteed, he said. If money market funds are breaking the buck left and right its over. But thats not going to happen. Theyll back them up with printed money if they have to.