Tensions run high over sovereign debt haircuts

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Banks might refuse to underwrite and distribute sovereign debt at risk of principal reduction.

The new year started uneasily in the debt markets, with 10-year Greek government bonds yielding 12.57% – higher than in the depths of the initial sovereign debt panic last May and Irish 10-year governments yielding 9%. Investors’ nerves are jangling as they await the next test of European policymakers’ capacity to contain the damage from the continued deleveraging of the western financial system.

Deutsche Bank points out that combined government and financial debt, which rarely ran above 100% of the GDP of the US, UK, or Europe until the mid-1990s, still stands at unprecedented levels as the fourth anniversary approaches of the financial crisis that began in the summer of 2007. In core Europe combined government and financial debt now stands at 164% of GDP; in the US, it is at 191%; it is at 213% for the UK and 214% in the European periphery. It would seem to be a lot to hope for that the western economies can grow robustly so as to make these debt levels look more comfortably sustainable.

Most debt market participants expect that in 2011 there will be repeats of the occasional closures of the capital markets that borrowers had to cope with in 2010. Issuers will struggle if these turn out to be prolonged. European banks have to repay or roll over €1.6 trillion of term funding in the next three years, with worrying maturity bulges in 2011 and 2012. They can do without prolonged market closures being prompted by investor worries about their exposures to troubled peripheral European sovereigns seeking any measure of debt forgiveness.

But policymakers, who have taken a much more interventionist approach since governments had to bail out their banking systems in 2008, have been vigorously pushing the idea of banks taking haircuts on sovereign debt since 2009. In 2011, it might finally happen, with consequences that still cannot be accurately forecast. Deutsche Bank calculates that total European bank exposure to the debts of five peripheral European sovereigns is about $2.2 trillion, with $770 billion of that to Greece and Ireland, which have already received bailouts, plus Portugal. A 10% haircut on the debts of these three weakest sovereigns would cost the banks $77 billion. Add in Spain and Italy and that would rise to $225 billion, or 19% of the market capitalization of the Stoxx 600 banks index. Let’s not even talk about a 20% haircut.

Deutsche Bank asks the question just as relevant at the start of 2011 as it was in the summer of 2007, the autumn of 2008 and the spring of 2009: have we been sleepwalking into a completely unsustainable financial system? And if the leverage cannot be sustained, will it be resolved by default, restructuring that destroys net present value, or inflation? None sound good.

No wonder investors and bankers are nervous. And the tension is starting to mount. Euromoney speaks to a senior executive at one of the leading European banks who points out that it is not only banks that have substantial rollover risk and funding programmes to worry about this year; sovereigns do too. There is a surprising edge to his words.

At the centre of its wholesale commercial and investment banking activities, the bank is a primary dealer in all the leading European government debt markets, a role that requires it to carry market-making inventory and take occasional principal underwriting positions as it accompanies sovereign clients on their funding operations. The bank has also boosted its holdings of government bonds over the past 18 months to bolster liquidity reserves at the insistence of regulators and indeed customers.

The executive says that if the bank is required to take haircuts on these government bonds, it will review its continued role as a primary dealer. He says this not for attribution: is it fighting talk, or an empty threat? Euromoney takes it as an indicator of extreme anxiety and an insight into the wrangling behind the scenes. Governments and banks are still up to their necks in this mess. If they fail to negotiate it together, other investors might yet take fright again, go on strike and refuse to buy, at any price, the debt of sovereigns or banks over which doubts about debt sustainability hang.

We hope Euromoney readers had a good break. It’s going to be a tough year.



Also this issue:
Market news: EU bailout bonds set for debut issue
Against the tide: It’s in the eurozone’s DNA
EU sovereign debt: Bondholders should bite restructuring bullet
Sovereign debt: Principles and practice