WASHINGTON – Three years ago, a financial crisis triggered by bad mortgage investments spread from U.S. banks to Europe. Panicky financial markets tanked.
Now, fear is running in the opposite direction. Worries about toxic government debt held by European banks have hammered U.S. stocks and threaten to freeze credit on both sides of the Atlantic.
And traders are wondering: Could Europe's government-debt crisis spread through the U.S. financial system?
No one's sure because no one knows how much toxic debt European banks hold — or how much risk that debt poses to U.S. banks. But investors are worried.
The 2008 financial crisis left countries like Greece, Ireland and Portugal holding huge debts. The three have required bailouts from the European Union and the International Monetary Fund totaling $520 billion. Italy and Spain, which are much bigger economies, might need bailouts, too.
As the crisis has intensified, Spanish and Italian interest rates have surged. Escalating rates could throw their economies back into recession — which would worsen their debt loads. This week, the European Central Bank started buying Italian and Spanish debt to try to drive rates back down.
Should Italy or Spain default, European banks that hold their bonds would suffer. Wall Street's fear is that the contagion would imperil U.S. banks that do business with those European banks.
French banks, with huge amounts of Italian and Greek government debt, are especially vulnerable. Shares in Societe Generale, France's No. 2 bank, plunged nearly 15 percent Wednesday on rumors it was teetering under the weight of debts tied to troubled Eurozone economies. The bank rejected the rumors as unfounded.
French regulators on Thursday banned short-selling of bank and insurance company stocks, preventing speculators from betting against them and driving their prices down when rumors flare. Societe Generale's stock recovered 3.7 percent Thursday. But most other European banks fell sharply.
Using data from European Union stress tests on 91 European banks, Fitch Ratings said losses of 50 percent on Greek bonds and 25 percent on Portuguese and Irish bonds wouldn't have made any of four big French banks flunk the test.
Still, investors were rattled this week by rumors that a credit rating agency was about to downgrade French government debt. Without France's AAA credit rating, Eurozone countries might be unable to raise enough money to bail out their weaker neighbors.
What most frightens investors is the worst-case scenario — the one that struck Wall Street in 2008: That banks would stop lending to each other because they're worried about each other's solvency. Since July 21, JPMorgan Chase's stock price has dropped 13 percent. Citigroup's has sunk 25 percent.
Major international banks are so intertwined that once they lose confidence in each other, fear spreads rapidly. And once it does, investors tend to panic and send stock markets plunging.
Rumors like the ones that pummeled Societe Generale and raised concerns about France's creditworthiness are "what panics are made of," says William Longbrake, former chief financial officer at Washington Mutual and now executive in residence at the University of Maryland.
In 2008, "Banks were suddenly afraid to lend to each other because they had no trust in ... other institutions," Longbrake said. "What happened yesterday in France is indicative of the same situation."
"It's starting to feel like it did in 2008," says Peter Tchir, who runs the hedge fund TF Market Advisors. "Someone says something about a bank, and boom — shares are down ... and people are panicking."
That said, 2011 isn't 2008. U.S. banks are sturdier now. They're holding more capital than in 2008, when collapsing home prices and mortgage-backed securities crushed Lehman Bros. and forced the government to rescue insurance giant American International Group. The toxic investments that are spooking markets this time are straightforward government debts, not exotic mortgage investments.
And U.S. banks have limited direct exposure — $39 billion — to the riskiest European countries, Portugal, Ireland, Italy, Greece and Spain, according to first-quarter U.S. government data analyzed by SNL Financial. That figure, a small fraction of U.S. banks' total assets, includes holdings of government debt and loans to banks and corporations.
But many worry that European governments aren't prepared to solve their crisis. Germany and other healthy countries, for instance, are balking at putting enough money in the European Union's rescue fund to rescue one of the larger countries.
The broader fear is that one of them, such as Italy, will default and damage European banks whose reach extends to the United States.
All that "could trigger a chain reaction whose final repercussions would be very difficult to predict," says Domenico Lombardi, senior fellow at the Brookings Institution.
Complicating the problem is that indebted European countries have tried to reduce debt by cutting spending. Those spending cuts tend to weaken their economies. The result is that their debt can get bigger, not smaller.
White House spokesman Jay Carney expressed confidence Thursday that "Europe's institutions have the capacity to handle this situation."
Still, the vulnerability of U.S. banks goes beyond their direct holdings of European debt, said Christopher Whalen, managing director at Institutional Risk Analytics. U.S. banks also rely on fees from European bank and corporate clients. And they run the risk they won't be able to collect on financial bets they've entered into with European banks.
Similar fears contributed to the panic that engulfed Wall Street in the fall of 2008.
Troubles with money-market mutual funds also worsened Wall Street's crisis three years ago. Investors withdrew their money once they realized the funds were exposed to losses on Lehman Brothers. Short-term credit markets that corporations rely on froze up.
Large U.S. money-market funds had 49.6 percent of their holdings in certificates of deposits, commercial paper and other instruments from European banks at the end of June, according to Fitch.
U.S. money market funds have been slashing their exposure to banks in the Eurozone. Their holdings of Eurozone bonds declined about 10 percent in July, to $340 billion from $378 billion, according to research from J.P. Morgan Securities LLC.
The Investment Company Institute, a mutual fund trade group, says U.S. funds have no holdings in the three bailed-out countries — Greece, Portugal, Ireland — and little exposure to Spain and Italy.
"Fund managers have been aware of these issues and have been taking actions for a long time to reduce their exposures to potential risks in Europe," said Sean Collins, senior director at the investment institute.
But Fitch has warned that if credit froze up, money market funds would find it difficult to avoid losses.
Associated Press Writers Martin Crutsinger and Marcy Gordon in Washington and David McHugh in Frankfurt, Germany, contributed to this article.