Market Overview

Italy Slowly Becoming Greece 2.0

It looks like Europe has finally drawn a line in the sand for bailouts. Just on the other side of that line is Italy.

According to Reuters, Europe has no plans at this time to rescue Italy, despite the fact that Italy's debt costs have risen above the level where they could reasonably be expected to pay them. Some economists have warned that Italy could default on their loans if some sort of restructuring or lifeline is not extended.

In other words: If you think Greece is bad, you're going to love Italy going down like the Titanic.

The biggest challenge for Italy is the size of their debt and the confidence-shaken markets. It's a classic case of debt-holders panicking when they should be confident, and demanding higher interest rates when they should be negotiating better terms.

The main assistance agency in Europe for countries at this stage of trouble is the European Financial Stability Facility. The EFSF steps in to offer proactive (rather than reactive) credit lines to nations that find themselves cut off from normal credit means. In Italy's case, the sovereign debt market has taken such a hit that borrowing costs have risen to approximately 7 percent on loans. This number is not something Italy can live with.

We have already seen Ireland and Portugal seek protection from the EFSF under similar circumstances. Unfortunately for Italy, Ireland and Portugal are much smaller economies with smaller debts. Simply put, the EFSF isn't designed for as large a failure as Italy would be, and they don't have the funds to help Italy out.

At this point, Italy has two paths forward to remain solvent. One, it can convince its creditors that it is solvent, and receive lower borrowing costs to repay their current and future obligations. This could involve some political maneuvering, which might be difficult with the Berlusconi government falling apart this week.

Two, Italy can appeal to the European Central Bank to step in, much like how the Federal Reserve might step in for the United States. The ECB could expand its balance sheet, again like the Fed does, and buy up Italian bonds. This would drive the costs down for Italy and keep the nation solvent.

As of now, there has been one round of purchases, but no definite, concrete agreement has been reached between Italy and the ECB. Hopefully, they are simply waiting for the dust to settle on the internal political situation in Italy before making a decision. Anything short of assistance from the ECB would mean one thing: Italy would be the new Greece, but larger and more damaging to world markets.

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