Italian media reported last month that Prime Minister Silvio Berlusconi had been caught on wiretaps making disparaging sexual comments about German Chancellor Angela Merkel.
A diplomatic blunder at any time, the insults were especially inopportune when the question haunting investors these days is whether Germany will get into bed with Italy.
European bank stocks have fallen as borrowing costs climbed in recent months amid rising concern that they may have to take greater losses on debt issued by Greece, Italy, Ireland, Portugal and Spain. As policy makers seek to make lenders hold more capital to absorb potential losses, investors and analysts say the banking crisis can’t be solved unless Germany, the region’s richest country, shows it’s willing to stand behind Italy and Spain, the two biggest debtors of the five countries.
“What needs to happen as part of this package is that the possibility, the discussion or even remote likelihood of haircuts on Spain and Italy needs to be killed and taken out of the market,” Philippe Bodereau, a portfolio manager and global head of financial institutions credit research at Pacific Investment Management Co., said in an Oct. 12 interview with Bloomberg Television. “Bank recapitalizations are necessary but not sufficient.”
Finding a way out of the European crisis will top the agenda at a meeting of G-20 finance ministers and central bankers in Paris this weekend. None of the proposed solutions -- whether they involve the European Central Bank or the 440 billion-euro ($606 billion) rescue fund known as the European Financial Stability Facility -- can work without Germany, and by proxy the ECB, offering blanket support to Italy, said former International Monetary Fund Chief Economist Simon Johnson.
“Does the ECB stand behind Italian debt like the Federal Reserve stands behind U.S. debt? That’s the only question,” said Johnson, now a professor at the Massachusetts Institute of Technology and a Bloomberg View columnist. “Everything else is derivative from that question. They won’t tell you that, and they can’t decide.”
German and French leaders pledged at a meeting Oct. 9 to devise a plan to recapitalize banks, help Greece and strengthen Europe’s economic governance. Merkel said after meeting with French President Nicolas Sarkozy that Europe will do “everything necessary” to ensure banks have enough capital.
All lenders judged by the region’s top banking regulator to be systemically important should be required to hold “temporarily higher” amounts of capital, European Commission President Jose Barroso said on Oct. 12. The European Banking Authority discussed making the banks hold core capital equal to at least 9 percent of their assets, up from a 5 percent core Tier 1 capital requirement imposed in the stress tests carried out by the regulator earlier this year, according to a person familiar with the proposals.
That might not calm investors, said John Raymond, an analyst at research firm CreditSights Inc. in London.
“You can’t analyze banks’ capital needs until you know what’s going to happen to the sovereign debt, and they haven’t told us,” Raymond said. “That’s the problem.”
The European Union moves come after this month’s breakup of Dexia SA, a Franco-Belgian lender, and a surprise 1.6 billion-euros in writedowns and provisions at Vienna-based Erste Group Bank AG illustrated the shortcomings of regulatory stress tests on about 90 of the region’s banks in July. Both Dexia and Erste passed the tests, which were criticized for failing to take into account potential markdowns on the value of government debt.
A new review should assess “all sovereign debt exposure in full transparency,” Barroso said. Government bonds will be valued more closely to current market prices than in the July stress tests, according to a person familiar with the matter.
Those new criteria would lead to a 220 billion-euro capital shortfall at 66 of the participating banks, with the biggest gaps at Edinburgh-based Royal Bank of Scotland Group Plc, Frankfurt-based Deutsche Bank AG and Paris-based BNP Paribas SA, according to a note published yesterday by Credit Suisse Group AG analysts.
The challenge is finding a source of capital. Requiring European governments to supply it would risk adding to the debt of countries already struggling with budget deficits, according to Alastair Wilson, chief credit officer for Europe, the Middle East and Africa at Moody’s Investors Service.
“Concern about the banks is driven in part by the sovereigns, which may be weakened by putting money into the banks,” Wilson said in an interview. “We have to recognize that there are consequences for sovereigns in recapitalizing the banking system.”
Efforts by banks to raise capital from the private sector will be hampered unless investors can be sure there’s a limit to potential losses on sovereign debt, Ralph Schlosstein, chief executive officer of Evercore Partners Inc., a New York-based investment bank, said in an interview.
“If you want to have any hope of getting money for the banks from private sources, you have to be able to tell them what these sovereign debt assets are worth,” Schlosstein said. Europe has to show it’s providing a convincing level of support to countries including Spain and Italy “as a precondition or simultaneous to a recapitalization of the banks.”
Greece, Italy, Ireland, Portugal and Spain, known as the GIIPS, have about 2.9 trillion euros of government bonds outstanding, according to data compiled by Bloomberg. Italy, the third-largest issuer of debt after the U.S. and Japan, accounts for more than half, or 1.59 trillion euros, the data show.
About 413 billion euros of GIIPS debt is held by 38 of Europe’s largest lenders, according to an analysis of the stress-test results by Alberto Gallo, a strategist at RBS in London. Those holdings equal almost 40 percent of the banks’ 1.1 trillion euros of equity, according to Gallo.
European banks, having agreed to a voluntary loss of about 21 percent, are bracing for further writedowns on Greece’s 288 billion euros of government bonds, which carry Moody’s second-lowest rating of Ca and an equivalent CC by Standard & Poor’s. European officials are considering writedowns of as much as 50 percent on Greek bonds as part of a revamped strategy to combat the crisis, people familiar with the discussions said.
Such losses could be dwarfed by writedowns on Italy’s debt.
“I can’t imagine a fund that is big enough to also guarantee Italy in total,” Martin Blessing, CEO of Frankfurt-based Commerzbank AG, said on Sept. 20, referring to the EU’s rescue fund, the EFSF, approved yesterday by Slovakia, the last of the 17 euro zone countries to do so. “Italy is a whole other situation than Greece.”
Berlusconi, the 75-year-old billionaire media tycoon and Italy’s longest-serving prime minister, today won a confidence vote in Parliament that he called earlier this week after the lower house failed to rubber stamp a 2010 budget report on Oct. 11. Last month he won approval for a 54 billion-euro package of budget cuts, the country’s second since July, which was adopted in exchange for ECB agreement to buy Italian bonds.
Mario Draghi, 64, the Bank of Italy governor who will become president of the ECB at the end of the month, said on Oct. 12 that Italy’s austerity plan won’t be sufficient because interest rates on the country’s debt could rise and create “a spiral that may end up being ungovernable.”
On Oct. 4, Moody’s cut its assessment of the nation’s long-term debt for the first time in almost two decades, lowering it three levels to A2 with a negative outlook, on concern that weak growth will hamper Berlusconi’s efforts to balance the budget. Italy’s debt is 119 percent of its gross domestic product, the second-highest in Europe behind Greece.
The downgrade meant Italy joined Spain, Ireland, Portugal, Cyprus and Greece as euro-region countries whose credit rating has been cut this year. Unlike Ireland and Portugal, which followed Greece in seeking bailouts from the European Union and the International Monetary Fund, Italy had managed to skirt the worst of the fallout from the debt crisis until this year.
Italian growth, 0.8 percent in the second quarter, has lagged behind the euro-region average for the past decade. Berlusconi told legislators yesterday that austerity may slow the economy further, and he promised tax, constitutional and judicial reforms to boost the economy.
Italy’s borrowing costs climbed and the value of its debt fell. The yield on the country’s 10-year bonds has risen to 5.80 percent from 4.88 percent at the end of June. The yield surged as high as 6.19 percent on Aug. 4 before the ECB announced plans to start buying Italian and Spanish bonds.
“The real issue is that panicky markets treat the sovereign debt of big and solvent countries such as Italy and Spain as toxic assets,” said Holger Schmieding, a London-based chief economist for Berenberg Bank. “If policy makers can convince markets that these assets are safe, there would be no need for banks to bolster their capital against an imaginary risk of an actual writedown on these assets.”
Unlike the U.S. and Japan, Italy can’t print money to buy its own debt when demand runs low. Instead, its central bank is a part of the ECB, whose strict mandate to combat inflation was influenced by Germany’s pre-World War II experience with hyperinflation.
German Finance Minister Wolfgang Schaeuble said this week that Europe won’t use loose monetary policy or “cheap money” to alleviate the region’s debt burden and argued last month that financial institutions should be required to share the burden of helping the most troubled nations.
“The challenge to bring crisis-hit countries back on track must not be left to taxpayers alone,” Schaeuble said in a Sept. 24 speech in Washington during the annual meeting of the Institute of International Finance.
Italian bonds are trading below face value because investors have determined the debt doesn’t have the full backing of the ECB, said Kenneth Rogoff, a Harvard University economics professor and former chief economist at the IMF.
“It’s clear that it doesn’t, because if it did it wouldn’t be selling at a discount,” Rogoff said. “It’s clear that it’s not unambiguous how far the ECB would go and how far the EFSF would go.”
Rules promulgated by the Basel Committee on Banking Supervision have encouraged banks to hold government bonds issued in their own countries’ currency because they’re treated as risk-free and highly liquid assets.
Rogoff, co-author of “This Time Is Different: Eight Centuries of Financial Folly,” said there’s a long history of governments creating rules designed to encourage banks to hold their own debt.
“Just think about it: If you’re the government regulating the bank, what kind of government’s going to say, ‘Don’t hold too much of our debt, because you know you can’t trust us’?” he said. “One of the arguments that proponents of bailouts often use is if we don’t bail out the country and we let the government default, the banking system may not come back for a decade. This is an old story.”
Josef Ackermann, 63, CEO of Deutsche Bank, Germany’s biggest lender, said at a conference in Berlin yesterday that “it is not the capital funding of banks that is the problem, but rather the fact that government bonds have lost their status as risk-free assets.”
Even talking about the need to recapitalize banks is harmful, he said.
Jean-Claude Trichet, 68, a Frenchman who is stepping down as ECB president after eight years in the role, warned on Oct. 11 that the region’s crisis “has reached a systemic dimension” because it has moved to some of Europe’s larger countries from the smaller economies.
His successor’s ability to pursue policies that would help Italy -- such as lower interest rates and ECB purchases of Italian debt -- will depend on whether Germany assents, said MIT’s Johnson. Policies pursued by the EFSF, which draws on money from all 17 euro-zone countries, also will be influenced by Germany, the fund’s largest contributor.
Asked in August if bailouts of euro-area nations unable to deal with widening budget deficits would be acceptable “even if they were necessary to keep the euro zone intact,” 59 percent of Germans disagreed and 20 percent agreed, according to a Bloomberg/YouGov Plc poll.
Berlusconi’s alleged remarks about Merkel haven’t been confirmed by the Italian government or prosecutors, whose wiretaps were reportedly the source of the recording. They were blogged about and commented on widely, including in Bild, Germany’s largest tabloid newspaper.
Berlusconi has never commented on reports of the remarks about Merkel and has condemned the use of wiretapping in investigations. Niccolo Ghedini, Berlusconi’s defense lawyer, couldn’t be reached on his mobile phone.
The Italian prime minister, who has been criticized for comments about women and diplomatic gaffes, faces four criminal charges, including one accusing him of paying for sex with a minor. Since entering politics, he has faced dozens of trials and investigations and, by his own count, has spent more than 400 million euros defending himself. He has said he is innocent of all charges and that Italian judges are out to destroy him.
“If you were a German taxpayer, how much would you be willing to pay to keep Silvio Berlusconi in the lifestyle to which he’s become accustomed? Not much,” Johnson said. “It’s a perception factor.”