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This new credit crunch seems so déjà vu

Coming soon: Credit Crunch Part II.

Early looks at the plot suggest it will be much the same as the first time around, freshened up with the usual sequel tropes of different exotic locales and a few new characters.

There will be tales of bad loans to dodgy borrowers in sunny climes leading to a loss of faith in the financial system, bank bailouts, dubious derivatives, and unexpected economic ripple effects that sideswipe everyone from Canadian oil producers to Chinese toy makers.

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Greek and Portuguese politicians take leading roles as the villains, instead of California and Arizona home buyers. The patsies, previously portrayed by Lehman Brothers and Citigroup, are now German and French banks. Brussels and Frankfurt sub in for Washington, where politicians sweat bailout after bailout as they race to save the world.

It starts a bit slow, but by the end it could be terrifying. That is, unless policy makers can find a way to cancel the sequel by stopping the steady ossification of European credit markets.

"There is a bit of a déjà vu feeling," says Roger Lowenstein, author of The End of Wall Street, which chronicles in impressive and depressing detail the madness that gripped U.S. banks and led many to ruin in the past decade.

More than a bit, actually. Reading The End of Wall Street, which came out last month, is like entering some sort of portal in time.

Read Boyd Erman's full Q&A with the author

One moment you are engrossed in the part about the Dow Jones industrial average taking a huge tumble as markets figure out just how bad the Lehman situation is; the next minute someone wanders by and says "Hey, the Dow's down 400 points." The only difference is this time it is sovereign debt not mortgages that trigger the anxiety.

There are the debtors blaming "speculators" rather than mismanagement for their own misery. There is the seizing up of the financial system with indicators such as the TED spread and Libor increasingly showing fears that banks are going to run into trouble.

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Credit default swaps that provide insurance against European banks failing are becoming increasingly expensive. Commercial paper markets are showing stress, threatening again to cut off financing for companies in all types of business.

"Traders in Europe clearly remember that there's never just one bug in the salad," Mr. Lowenstein says. Greece may be just a harbinger of more problems to come, as the troubles at Bear Stearns Holdings Inc. were.

"Markets are saying if we couldn't trust Citi and Merrill Lynch why should we trust Portugal?"

Yet again, it can all be traced back to bad debt at the banks. U.S. banks lent too much to barely solvent homeowners who fibbed about their earnings and ability to repay. Europe's banks lent too much to barely solvent governments that lied about their finances. Both times, regulators who were supposed to be watching were asleep.

Once again, the concern is that financial institutions will end up with big losses that will force them to cut back on lending.

Traders in Europe clearly remember that there's never just one bug in the salad. Roger Lowenstein, author of The End of Wall Street

That's when financial sector problems become wider economic problems. "That's when you get these 15-car pileups on the highway," Mr. Lowenstein says.

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Just as the U.S. mortgage mess found its way across the seas, Europe's problems are not confined to the continent.

China's stock market is plunging and economists warn that trade may shut down if European banks start to shun the letters of credit upon which Chinese exporters depend to make sales. Oil and other commodities are being slammed on fears of a slowing China. Canada's resource sector is collateral damage.

Yet as bad as it could be, there's a sense that in the broader world, many remain unaware.

That's also a familiar plot feature. There were six months between the near-failure and fire sale of Bear Stearns in March, 2008, and the rapid series of crises that marked the worst of the financial collapse in September of that year. All the while, Main Street had little idea what was coming down the pipe - a monster that we now know as the Great Recession.

Can regulators avoid having bad loans to governments trigger the double-dip recession that until recently seemed to be a forgotten risk?

As Mr. Lowenstein points out, once the bad loans are made, there aren't many options. In 2008, "once the loans were on the books I'm not sure there was a soft landing" possible.

If that's true, Credit Crunch II could be pretty tough to watch.


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