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Rising Italy-to-Spain Yields Keep Banks on Life Support

Rising Italy-to-Spain Yields Keeping Banks on ECB’s Life Support
Intesa Sanpaolo SpA paid investors 3.55 percentage points more than the benchmark on a five-year bond it sold in February. Photographer: Alessia Pierdomenico/Bloomberg

European lenders, more reliant than ever on emergency aid after borrowing $1.3 trillion from their central bank, may need additional cash infusions until policy makers stem the crisis engulfing Spain and Italy.

After more than 30 bond sales in the first quarter, no bank has sold unsecured debt this month, and the cost of insuring against default has soared to levels last seen in January. Financial stocks, which rallied 20 percent following the European Central Bank’s December decision to provide unlimited three-year loans, are now 2 percent lower since then.

Investors are balking after some lenders used the ECB cash to boost holdings of sovereign debt and governments struggled to rein in deficits. Because banks post collateral in exchange for the ECB loans, the amount unsecured bondholders would get back in a default has shrunk. That has raised funding costs for what Morgan Stanley estimates is about 700 billion euros ($924 billion) of debt lenders must refinance by the end of 2013.

“There is a very compelling case for further intervention from the ECB,” said Barbara Ridpath, chief executive officer of the International Centre for Financial Regulation, a London-based research group funded by banks and the U.K. government. “Many of these banks simply cannot refinance their maturing debt in the bond market.”

BBVA, Intesa

The requirement that banks post collateral in return for ECB loans already is making it costlier to raise money from bondholders. That, combined with a rise in the sale of asset-backed covered bonds and proposed rules forcing debt investors to share any losses, will make senior unsecured debt less attractive, said Andrew Stimpson, a KBW Inc. analyst in London.

Banco Bilbao Vizcaya Argentaria SA offered investors 1.93 percentage points more than the benchmark swap rate when it issued an 18-month senior note in February. That compares with 0.45 percentage point above the benchmark rate when the Bilbao, Spain-based lender sold a 10-year bond in May 2007, according to data compiled by Bloomberg.

Intesa Sanpaolo SpA paid investors 3.55 percentage points more than the benchmark on a five-year bond it sold in February. The Milan-based bank sold a 10-year security for 0.18 percentage point more than the mid-swap rate in 2008, the data show.

The jump in borrowing costs comes as banks face declining profits and shrinking revenues. The yield paid by Italian lenders on secured debt would be unsustainable in the long term, Stimpson said.

‘Ever-Worsening Pool’

“Holders of unsecured bonds are being left with access to an ever-worsening pool of collateral in the event of default,” said James Ferguson, chief strategist at London-based stockbroker Westhouse Securities Ltd. “As acceptable collateral is siphoned out of the system by the ECB, high-quality collateral shortages in the private sector will therefore push up banks’ funding costs.”

The Frankfurt-based ECB began its emergency longer-term refinancing operation, or LTRO, after bank funding markets froze and yields on southern European government debt hit euro-era records last year. Lenders in the region borrowed 489 billion euros in December and 530 billion euros in February, according to the central bank.

The move initially helped boost bank stocks and ease concern that lenders weren’t creditworthy. The 43-member Bloomberg Europe Banks and Financial Services Index rose 20 percent from before the Dec. 8 announcement to March 19. The Markit iTraxx Financial Index of credit-default swaps, which measures the likelihood of default of 25 European banks, dropped from a peak of 354 on Nov. 24 to a low of 180 on March 20.

‘Markets Lose Faith’

Since then, bank stocks have fallen 16 percent, while the iTraxx financial index has climbed to 256 as investors question whether Europe can escape a prolonged recession.

“The first LTRO was powerful, the second was less powerful and a third one could be even less so as markets lose faith the measures will bring lasting change,” said Philippe Bodereau, London-based head of European credit research at Pacific Investment Management Co., the world’s largest bond investor. “The main benefit was to avoid a refinancing crisis in European banking, but the issue is the systemic nature of Spain and Italy and their government bond markets and how you stabilize that.”

The Spanish government said March 2 it would miss its 2012 budget deficit target, and Italy said last week it would fail to reach its goal after lowering growth forecasts.

Spanish Yields

Yields on two-year Spanish government debt have climbed 1.26 percentage points to 3.4 percent since March 1. Two-year Italian yields have climbed 1.22 percentage points over the same period to 3.39 percent. Ten-year Spanish yields broke through 6 percent on April 11 for the first time since December.

In France, socialist candidate Francois Hollande, who has proposed increasing state spending by 20 billion euros over five years, is the front-runner in the presidential elections after beating incumbent Nicolas Sarkozy in the first round on April 22. In the Netherlands, Prime Minister Mark Rutte tendered his cabinet’s resignation this week after failing to garner support for proposed spending cuts.

Under pressure from their governments, lenders in Spain and Italy used ECB loans to buy sovereign debt. Spanish bank holdings of government bonds jumped 26 percent to 220 billion euros in the two months through the end of January, data from Spain’s treasury show. Italian banks increased ownership of their nation’s bonds by 31 percent to 267 billion euros in the three months ended in February, according to Bank of Italy data.

‘Aggravating Europe’s Problems’

“The LTRO may be aggravating Europe’s problems by encouraging peripheral European banks to buy more sovereign debt and postpone the necessary deleveraging of their balance sheets,” Thomas Higgins, a strategist at investment-management firm Standish, a subsidiary of Bank of New York Mellon Corp., wrote in an April note to investors. “It is easy to imagine a scenario in which sovereign spreads in Spain and Italy continue to widen, placing bank balance sheets in a precarious position” as the value of their sovereign bonds shrinks.

With European banks holding a combined $807 billion of Spanish and Italian government bonds at the end of September, according to data compiled by Bloomberg, the ECB may be forced to continue propping up lenders until investors are convinced that the risk of a sovereign default has dissipated.

“The outcome for Spain and Italy is binary,” Mike Harrison, an analyst at Barclays Plc in London, said in an interview. “Either they are absolutely fine or there’s a really big problem. In that environment, it’s difficult for banks to attract investors and stand on their own two feet.”

European banks including BNP Paribas SA and Deutsche Bank AG could be forced to sell as much as $3.8 trillion in assets through the end of next year and curb lending if governments fall short of their pledges to stem the sovereign-debt crisis, the International Monetary Fund said in a report last week.

Bundesbank Opposition

Any repeat of the LTRO could encounter opposition from central bank council members. Jens Weidmann, president of Germany’s Bundesbank, wrote to ECB President Mario Draghi in February questioning the decision to loosen collateral requirements, which has left the central bank holding more assets of lower quality.

“With these measures, we’re only buying time,” Weidmann said at a March 13 press conference. “This time has to be used to get to the roots of the sovereign-debt crisis. It’s important to reduce the dependency of banks on central-bank funding.”

Rather than inject more cash into the region’s banks, the ECB could restart its Securities Markets Program, through which the central bank buys sovereign debt in the secondary market to bring down yields. Of 22 economists polled this month by Bloomberg News, 17 predicted the ECB would resume the program.

These bond purchases, mothballed a month ago after the introduction of the LTRO, have split the ECB Governing Council, with German policy makers arguing they fall outside the remit of monetary policy and aren’t effective. Weidmann said in December that he’s “not a fan.”

Temporary Measures

The ECB still describes its funding measures as temporary, limited and non-standard almost five years after it first injected 95 billion euros into the financial system, when Paris-based BNP Paribas halted withdrawals from three funds. There’s little sign the central bank’s measures will end anytime soon.

“We are already approaching the half-decade anniversary of so-called ‘emergency’ liquidity support,” Barclays’s Harrison and colleague Simon Samuels wrote in a March 19 report. “Given the intractable nature of some of the issues, it seems entirely plausible that this could carry on for many, many more years.”

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