Europe's Catch-22 Bond Crisis

Selling risky bonds to protect banks could hasten defaults

Under pressure from regulators, European banks are unloading risky sovereign bonds to shore up their balance sheets. Yet the move to strengthen the banks may have a perverse consequence: raising the cost of borrowing for struggling governments, thereby worsening the region’s debt crisis. “European regulators and leaders are shooting themselves in the foot,” says Otto Dichtl, a London-based credit analyst at Knight Capital Europe. “The downward spiral will continue until policymakers find a backup solution for the sovereigns.”

Banks across the region are reducing their exposure to debt of southern European nations as regulators demand higher reserves to shoulder possible losses. European banks cut their foreign lending to the Greek public sector to $37 billion as of June 30 from $52 billion at the end of 2010, according to the latest data from the Bank for International Settlements. European banks lending to the Irish, Portuguese, and Spanish public sectors also fell, data from Basel (Switzerland)-based BIS show.

In recent weeks, BNP Paribas and Commerzbank have said they sold sovereign bonds at a loss, and Barclays and Royal Bank of Scotland announced reductions in holdings. “You can’t really blame BNP or other European banks for selling sovereign debt,” says Christophe Nijdam, an AlphaValue bank analyst in Paris. “You don’t want to wait to see what happens for Italy and Spain.” Banks can cut their exposure through writedowns and by hedging and letting bonds mature, as well as by selling.

Such moves have helped push down bond prices, raising yields on existing debt—and forcing governments to pay higher rates when they sell bonds. Greek bond prices have dropped 42 percent since July, the most among 26 sovereign debt markets tracked by Bloomberg/European Federation of Financial Analysts Societies indexes. Italian debt declined 8 percent and Portuguese 5 percent. The impact of falling prices spread to New York on Oct. 31, when MF Global, run by Jon Corzine, filed for bankruptcy protection after making a $6.3 billion bet on European sovereign debt.

While it’s hard to determine who’s buying the bonds, Knight Capital’s Dichtl says that beyond purchases by the European Central Bank, some hedge funds or distressed-asset investors may be acquiring Greek government bonds, and money managers and pension funds are still purchasing Italian debt.

Of about €355 billion ($491 billion) in outstanding Greek debt, the European Union, the International Monetary Fund, and the ECB hold about €127 billion, and European banks, led by Greek lenders, have about €90 billion, according to estimates by Open Europe, a research group based in London and Brussels. Foreign nonbanks such as hedge funds and insurers have about €80 billion. Scarce data makes estimates difficult, according to Raoul Ruparel, an analyst at Open Europe.

In the past, domestic banks in countries such as Greece and Ireland “filled the gap” when foreign demand for their nations’ bonds slipped, says Alberto Gallo, head of European credit strategy at RBS in Edinburgh. “The question is how to disentangle the link between banks and sovereigns,” says Gallo, who described the situation as a Catch-22. If you force the banks to sell bonds, you risk creating a vicious cycle that will drive down prices, he says, adding, “If you don’t, you end up with a bank system very correlated with sovereign bonds and vulnerable to shocks.”


    The bottom line: European banks cut lending to the Greek public sector by $15 billion during the first half of the year, helping to push down bond prices.

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