Over the last several months, the world has watched the events in Europe unfold with a sense of disbelief mixed in with a measure of anxiety. The disbelief comes from the fact that many investors must be asking themselves how the world could be confronting yet another credit crisis – when we just seemed to be finished papering over the last one. The anxiety comes from the fact that there are some prognosticators who believe that Greece is just the tip of the iceberg – and other European nations such as Portugal, Italy, Ireland, and Spain are next on the bailout list. Many observers believe that the very existence of the Euro and the European Union is being called into question.

Greece’s citizens are finding out firsthand the implications of a government that has allowed a disregard for fiscal discipline to run unchecked. The cost is real. Greece is trying to take corrective measures to deal with its debt crisis by enacting wage rollbacks, pension benefit reductions, cuts to government programs and higher taxes. This is a tall order at the best of times let alone when your fellow members of the European Union (i.e. your bankers) are facing reluctant voters at home who would rather see Greece kicked out of the European Union.

The recent aid package announced this past weekend in which almost $145 billion (more than twice the originally proposed $58 billion) in loans would be used to prop up Greece over the next three years. It was supposed to have calmed the markets. Instead, the markets have shrugged it off and Greek interest rates are still rising. In part, nobody seems to believe that the Greeks can deliver on their promised return to fiscal responsibility. The Euro has continued to fall and the response by the Greek population is one of shock and anger.

As the Greek government has tried to implement very tough spending controls, its citizens have responded with anger. Last month, Greece’s air force showed its displeasure as several members of the air force decided to “take an unscheduled day off” and the country has seen some violent protests.

Most individuals in North America might believe that this is a European problem and does not impact them. For the most part this is true – thus far. What we are seeing is a general aversion to sovereign credit. The markets are telling governments that “We are not confident in your abilities to pay back the money that you owe”. If this aversion continues, governments will have to offer greater incentive to investors in order to sell their debt. Recently, before the aid package was announced, Greek two-year bonds were seen yielding 18% -indicating that the markets viewed them as being high risk.

The shockwaves from the Greek debt crisis have sent the yields on corporate bonds higher as investors have decided to reign in their appetite for risk assets. The Euro has tumbled, the US dollar seems to be regaining some respect and investors have shrugged off a fairly decent performance from corporations that have reported recent quarterly earnings.

Ironically, only a few short weeks ago, Greece was able to float a bond issue to investors that saw such significant demand that it was oversubscribed. But this was not to last as these bonds quickly began trading for less than their issue price – a sign that some investors underestimated the extent of the Greek debt crisis.

The real issue that has not gotten so much attention is the level of debt exposure the commercial banking industry has to debt issued by the PIIGS. The chart below shows that the European banks have over $2 trillion in debt exposure to the PIIGS group of countries.

(Click on chart to enlarge - Courtesy: Barrons Online)

This is one of the real reasons (along with trying to maintain the credibility of the Euro) that the European Union countries have no choice but to try to stabilize the sovereign debt crisis.For those who think this is a European problem, we have to look at the involvement of the International Monetary Fund (IMF) which will contribute about 30% of the funds to Greece. The largest shareholder in the IMF is the US which means US taxpayers will be contributing a large portion of the rescue package.

It is perhaps amazing that this issue has not come to the front in political discussion yet in the US. For that matter, Canadians are also seemingly quiet on this issue. Given how much political backlash there was for bailing out GM, the banks or other industries during the financial crisis - this is surprising.

The crisis in Greece is nowhere near the size of the one that enveloped the financial markets nearly two years ago – but it is significant. The question is whether or not this crisis will become a contagion.

For investors, there are always winners and losers in every crisis – and opportunity to be had. The problem is that too many investors were caught flat footed by this crisis as it has been bubbling for some time. Hence, the violent reaction we are now seeing in the financial markets.

As we have commented before, complacency levels had set in amongst investors over the last several months and we know from history, that complacency is often replaced with panic.