European sovereign bond market faces big test in 2010
WHEN YOUR POPULARITY among investors plummets faster than you can say "Tiger Woods sponsorship deals", you know you have a problem. That seems to be the case for European banks. Bank of America Merrill Lynch’s benchmark February investor survey revealed that the banking sector’s popularity plummeted by the biggest-ever margin since the poll began in 2001.
It is the most negative investors have been on banks since March last year, and the largest conviction underweight position for any sector in seven months. Not the sort of news you want to hear when you have €500 billion to refinance this year.
It is a reflection of how interconnected the finances of banks and governments are in Europe. Not only do banks face risks to profitability via slowing loan growth and worsening asset quality as austerity plans to rein in bloated deficits are implemented, but more directly banks face big losses on the government bonds they hold on their balance sheets. To make matters more troublesome, funding costs are also on the rise, particularly for southern European banks. Yet they can hardly be accused of being reckless for investing in so-called risk-free debt. Indeed, it may very well be the governments of Europe and the capital regulators that have planted the seeds of this new banking crisis.
Since the European Union was formed, its banks have been encouraged by governments and regulators to bolster their balance sheets with liquid assets, sovereign bonds being the asset of choice. In return, capital regulators assigned the same zero-risk weighting to those assets, whether they be Greek bonds or German bonds.
"When governments look at themselves in the mirror they will realize they have an enormous responsibility, and they will have to honour that for their banking system," says Graham Bishop, an independent consultant on European financial affairs. "Even now there are proposals out there to encourage the banking system to put its most liquid assets into the worst possible government debt. And that’s stupid to say the least."
At the union’s foundation 20 years ago Bishop, in his capacity as Salomon Brothers’ adviser on EU financial affairs, argued strongly to European authorities that zero-risk weightings were an outmoded concept within a monetary union. If a sovereign state didn’t have the ability to print its own money, it lost the capability to pay its debts by printing money rather than raising taxes. He recalls that it was an issue European politicians found too difficult to confront. Now the chickens have come home to roost.
The Mediterranean menace
So far this year, Greek bonds have lost investors 3.4% on an annualized basis, as yields have risen 180 basis points. Portugal’s benchmark 10-year bond yield has risen about 30bp, and was as high as 80bp. Now investors nervously await a decision by EU finance ministers on March 16 after Greece provides more details on how it plans to cut its ballooning deficit from 12.7% of GDP in 2009 to 3% of GDP by 2012. The plan will likely include increasing value-added tax rates, taxes on energy products and further cuts to government expenditure. Next in line is Portugal (see Portugal tries to show how it’s different, Euromoney, March 2010), where Moody’s has assigned a negative outlook to its Aa2 rating. It too faces robust measures to strengthen the economy and adjust its public finances, and could face further ratings downgrades, although its outstanding debt is much less than in either Spain or Greece. However, there is a fine line to be walked for policymakers between curbing Europe’s most profligate members and sending the region into recession.
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"Governments will have to stand by the moral hazard they have recklessly created. They were warned 20 years ago"
Graham Bishop |
"If you get too much of a fiscal tightening all across the eurozone at the same time it would present a real risk to the European recovery," says Michael Krautzberger, head of euro fixed income at BlackRock. "European banks hold a substantial amount of Greek assets and therefore the crisis cannot be allowed to get out of control."
At the end of the third quarter of 2009, there was $1.3 trillion in Spanish, Portuguese and Greek debt outstanding. UK and continental European banks are the most exposed to the three countries, accounting for 92% of total foreign bank exposure to public and private sector borrowers, of which around 20% is government debt, or $265 billion. Within that, German and French banks account for almost half the total bank exposure, according to BCA Research. Government debt is about 8% of the European banking sector’s asset base and in some cases more, notes JPMorgan. In some countries, such as Greece and Spain, that level has risen significantly since the ECB introduced special liquidity schemes in the wake of the banking crisis.
Most of these bonds are typically held on so-called treasury trading books within banks, which were reluctant to discuss their exposures with Euromoney. However, the head of risk at one leading European bank told Euromoney that the hedging of sovereign debt price risk was almost non-existent and that that was typical of all European banks, because the cost of risk management using credit default swaps was prohibitively expensive. Some hedging was taking place using interest rate swaps to shorten the duration of the positions, he added.
The banker also noted that, despite the risks European banks are holding, they remain the most likely buyers of Greek bonds, given that Greek banks only hold €40 billion out of €300 billion of outstanding debt, and that pension funds and insurance companies remain overweight and are less willing to participate in future deals.
Graham Bishop argues that, if a country is going to be in the excessive deficit procedure, it should stop being zero risk-weighted and face penalties for failing to behave properly. Given the real risk of a sovereign default in the region, he says it will become harder and harder for finance ministers to tell the banking sector it can lend governments money and book it as zero risk.
