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Gentlemen fall for bonds

The continuing European financial crisis shows even government bonds can become dodgy. What happened to make bonds the latest nonperforming asset?

world Updated: Nov 13, 2011 01:12 IST

As the bets that European banks made on United States mortgage investments went bust a few years ago, bankers piled into what they saw as a safe refuge: bonds issued by countries in Europe’s supposedly ironclad monetary union.

Now, the political and financial crisis engulfing the continent has turned much of that European sovereign debt into the latest distressed asset, sending tremors through global financial markets not seen since the demise of the investment bank Lehman Brothers more than three years ago.

This past week, shortly after European leaders formally conceded Greece could not pay its debts and forced banks to accept losses, the shock waves reached Italy, the third-largest economy in the euro zone.

“When people started buying more European sovereign debt, there was not a cloud in the sky,” said Yannis Stournaras of the Foundation for Economic and Industrial Research, Athens. Now “this crisis is going to last because the perceptions of risk have changed dramatically.”

European banks face possibly hundreds of billions of dollars in losses on loans to euro-using nations. Worried about greater losses if the crisis worsens, banks have been dumping an investment that, like triple-A-rated subprime mortgage bonds, was once thought bulletproof. French bank Société Générale marked down 333 million euros of its Greek sovereign debt holdings and in October slashed exposure to that country to 575 million euros, down from 2.4 billion euros at 2011 start. France’s BNP Paribas has cut holdings of Italian government debt 40% since July.

NEW SUBPRIME
How European sovereign debt became the new subprime is a story with many culprits: governments that borrowed beyond their means, regulators who permitted banks to treat the bonds as risk-free and investors who did not distinguish between the bonds of a shaky Greece and a solid Germany.

Banks had further incentive to overlook the perils of individual euro zone countries because of the fees earned by underwriting sovereign debt sold to other investors.

Like other investors, banks clung for a long time to the myth that all euro countries would make good on their debts. For years, Greek and Italian bonds did not pay much more than German ones, but banks were hungry for even a fraction of additional profit. They bought the higher-yield bonds, ignoring the growing fiscal problems of nations like Ireland, Spain and Portugal.

Regulators bear responsibility. Before 1999, when Europe forged its monetary union, regulators permitted banks to treat the debt of any country belonged to the Organization for Economic Cooperation and Development, a rich nations club, as debt-free.

“There was encouragement from European authorities for banks to load up on more debt, because it was seen as safe,” said Nicolas Véron of Bruegel, a Brussels research firm. If anything, during the subprime crisis, Europe’s regulators added to the problem by demanding banks hold more sovereign debt.

Now, banks like Société Générale can’t get rid of shaky debt fast enough. Even then, their bond exposure remains high. European banks still hold $ 120 billion in Greek, $643 billion of Spanish and $837 billion of Italian debt. US banks have $47 billion exposure to Italian debt alone.

Banks insist the risks are manageable but regulators fear they do not have enough capital to cover a euro zone shakeup — as seen by the recent bankruptcy of debt-hit MF Global.

FALSE SHELTER
While the markets are now brutally efficient in telegraphing the differing debt risks among European countries, they failed in that function for a long time, just as they failed to reflect the risks of subprime mortgage loans.

For most of the last decade, bond yields among Germany, Greece, Portugal, Ireland, Italy and Spain traveled in a tight pack.

That meant bond investors acted as if the countries were equally safe simply because they were euro zone members, despite shaky Greek finances, high Italian debt and real estate bubbles in Ireland and Spain.

The phenomenon rang alarm bells even in 2005, when banks, national treasuries and the European Commission held intense internal debates on why the spreads between Germany and other countries did not reflect differing risks.

But all was forgotten when the subprime crisis made shelter-seeking banks to turn even more to European sovereign debt. Bank lending to the governments of Portugal, Ireland, Italy, Greece and Spain rose by 24.2 %, to $827 billion, between the mid-2007 and the third quarter of 2009.

Bit banks were also collecting fees on bond sale, giving them little incentive to publicize red flags even if they were suspicious about sovereign debt. In 2005, Marc Flandreau, a Lehman Brothers advisor, suddenly wondered if France’s finances were solid enough to merit the low interest rates on its bonds.

He wrote a memo to the French Treasury expressing his concerns. “They went totally ballistic,” Flandreau recalled. “They said, ‘You guys should shut up, you’re selling our stuff.’”

Today, with Europe’s sovereign debt crisis seemingly spinning out of control, regulators are pressing governments and banks to divulge as much risk as they can and are asking banks to set aside billions of euros to protect against possible losses.
“Sovereign debt has lost its apparent risk-free status,” Hervé Hannoun, deputy director general of the Bank for International Settlements, said in a recent speech in which he called for an end to “the fiction.”

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