Markets swoon, hit by thunderbolt news of a Greek debt referendum

Stock markets in the US and Europe fell Tuesday, stunned by news that Greeks will vote in January on national austerity measures tied to resolving Greece's sovereign debt woes.

Only last week investors were plowing money into stocks, making October one of the market's strongest months ever. Now they can't sell stocks fast enough.

As of noon Tuesday, the widely watched Dow Jones Industrial Average had fallen about 300 points, after losing 276 points on Monday. What happened? In a word: Greece.

After Greek Prime Minister George Papandreou announced a January referendum on national austerity measures, US and European stock markets began drawing up scenarios – almost none of them positive.

“If the austerity plan is shot down [by Greek voters], then do the European Union and the IMF [International Monetary Fund] lend Greece any more money?” asks Jay Bryson, an international economist at Wells Fargo Securities in Charlotte, N.C. “If not, then we are looking at a default here.”

“People are saying if Greece votes down the austerity plan, they are out of the eurozone,” says Eric Stein, a vice president of Eaton Vance Management in Boston. “In a best-case scenario, they vote in favor of the plan and resolve the issue. But there is also a big chance of a downside scenario where they vote down the plan and the government of Greece gets no more aid and is forced to restructure its debt or do more politically unpopular things.”

It’s not the prospect for a Greek default that is bothering investors, says Wells Fargo's Mr. Bryson. Greece owes only about €400 billion. “The question is what happens to Spain and Italy,” he says.

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Italy owes about €2 trillion in debt and Spain another €1 trillion, he says. Under a worst-case scenario, the two nations default on their debt, causing another global financial crisis, à la Lehman Brothers in 2008. US-based banks have exposure to about $150 billion in debts to Spain and Italy but $1.5 trillion to other banks in France and Germany, which own trillions of dollars of other European sovereign debt.

“Will the German and French banks collapse?” Bryson asks. “I don’t think that will happen.”

On Tuesday, investors continued to shed bonds issued to the Italian government.

On Monday investors got a Halloween-type preview of potential dangers in the European debt situation when MF Global, a large commodity trading operation run by former New Jersey Gov. Jon Corzine, declared bankruptcy.

MF Global had $6.3 billion in European sovereign debt on its books, as Mr. Corzine, also a former top executive at Goldman Sachs, tried to make MF Global into a company that used its own capital to trade. His big bet: European debt. Complicating the MF situation, regulators are now looking into the possibility that the company commingled customer funds with its money.

“This has spilled over into another minor financial mess,” says Fred Dickson, chief investment strategist at D.A. Davidson & Co. in Lake Oswego, Ore.

Mr. Dickson views the European debt problem as a play with many acts. “It will continue to play out until they [European nations] get their economies going and governments get their fiscal spending levels reduced.”

Dickson says the US stock market will get over its “Euro shock” in a day or two. “I expect there will be some announcement designed to placate the financial markets,” he says.

This weekend the G20 will meet in Cannes, France. Leaders need to implement the eurozone rescue deal in full and coordinate stimulative measures to avert a second global recession, writes Jan Randolph, the head of sovereign risk for IHS Global Insight writes in a preview of the meeting.

So far, European nations have yet to complete the funding of €400 billion for the European Financial Stability Facility, which is supposed to help combat the debt crisis. Recently, European leaders said they would expand the fund to €1 trillion.

“Delays in implementation to raise EZ [eurozone] bank capital, enhance the EFSF [European Financial Stability Facility] bailout fund’s firepower to 1 trillion euros and cauterize Greek government debt, still threaten massive seizure in global banking and thereby precipitate a global recession,” he writes.

The stock and bond markets will also be watching the actions of the Federal Reserve, which meets Tuesday and Wednesday. Mr. Stein does not expect much news from the actual announcement the Fed makes at the end of every meeting. But Fed Chairman Ben Bernanke will take questions from the media afterward.

“I think the reporters will be pushing him on the Greek debt issue,” says Stein.