Feeding Europe's Drug Addiction

Banks Gorging on Sovereign Bonds Shifts Risk

A drug addict lays on the ground in central Athens. Addicts have been a presence in Athens city center for more than 20 years, but with the recent crisis, things are getting worse for them, according to Philippos Dragoumis, president of a municipal center for prevention.

By Yalman Onaran

Spanish, Italian and Portuguese banks are loading up on bonds issued by their own governments, a move that shifts more of the risk of sovereign default to European taxpayers from private creditors.

Holdings of Spanish government debt by lenders based in the country jumped 26 percent in two months, to 220 billion euros ($289 billion) at the end of January, data from Spain’s treasury show. Italian banks increased ownership of their nation’s sovereign bonds by 31 percent to 267 billion euros in the three months ended in February, according to Bank of Italy data.

German and French banks, meanwhile, have cut holdings of those countries’ bonds, as well as Irish and Greek debt, by as much as 50 percent since 2010 in some cases. That leaves domestic firms on the hook for a restructuring such as Greece’s last month and their main financier, the European Central Bank, facing losses. Like Greece, governments would have to rescue their lenders with funds borrowed from the European Union.

“The more banks stop cross-border lending, the more the ECB steps in to do the financing,” said Guntram Wolff, deputy director of Bruegel, a Brussels-based research institute. “So the exposure of the core countries to the periphery is shifting from the private to the public sector.”

ECB Lending

The jump in sovereign-debt holdings by Spanish and Italian banks has been fueled by the ECB’s 1 trillion-euro long-term refinancing operation, or LTRO, initiated in December, to provide liquidity to the region’s lenders. Encouraged by their governments to take the money and buy bonds, banks borrowed 489 billion euros on Dec. 21 and 530 billion euros on Feb. 29.

For lenders in so-called peripheral countries -- Spain, Portugal, Ireland, Greece and Italy -- profit also was an inducement: They could borrow at 1 percent to buy government bonds yielding between 6 percent and 13 percent.

Lenders in those five countries have taken about 715 billion euros from the ECB through emergency programs, including the LTRO, according to the most recent data provided by the central banks of those nations. Irish and Greek lenders have borrowed an additional 83 billion euros from their central banks, using collateral that isn’t accepted by the ECB.

The bond purchases helped bring down borrowing costs at first. The yield on Spain’s benchmark 10-year bond dropped below 5 percent in January from more than 6.5 percent in November. Concerns that a deepening recession will lead the government to default on its bonds have driven yields back to 6 percent and the cost of insuring Spanish debt to levels that prompted other European countries to seek bailouts.

Ireland, Portugal

Irish banks increased ownership of that nation’s sovereign debt by 21 percent in the three months ended in February, according to the Central Bank of Ireland.

Government-bond holdings by Portuguese banks jumped 15 percent to 30 billion euros in the same period, according to ECB data. While the central bank doesn’t provide a breakdown of the holdings by country, most debt sold by Portugal in recent months has been snapped up by its own lenders, according to two primary dealers who serve as middlemen in the sales and who asked not to be identified because the information isn’t public.

French and German banks bought the sovereign debt of other European countries last decade as the region’s financial sector became more integrated and interest rates declined. That process has been fragmented by the debt crisis.

Since 2010, banks in France and Germany have retreated, cutting lending to the governments of Spain, Portugal, Ireland and Greece 42 percent, according to data compiled by the Bank for International Settlements. Dumping Italian sovereign bonds began more recently, with German lenders reducing their Italian holdings 13 percent in the second and third quarters of 2011, BIS data show. French banks shrunk their holdings of Italian government debt about 25 percent in the third quarter.

Debt Relief

While French and German banks lost money on Greece’s restructuring last month, a delay of more than a year allowed a similar shift of risk to the public sector. When the exchange took place, the debt relief was capped at 59 billion euros because fewer bonds were held by the private sector, including banks outside the country. If Greece had defaulted in 2010, the reduction could have been as much as 232 billion euros.

Greece had to borrow an additional 49 billion euros from the International Monetary Fund and the EU to recapitalize Greek banks that couldn’t handle losses on their sovereign-debt holdings during the restructuring.

“If there’s a private-sector restructuring of Portuguese sovereign debt, then Portugal’s banks will need a bailout like Greek banks did,” Dimitri Papadimitriou, president of the Levy Economics Institute at Bard College in Annandale-on-Hudson, New York, said in an interview.

Regulatory Pressure

In Spain, stronger banks such as Banco Santander SA (SAN), the country’s largest lender, can handle losses from their sovereign holdings, while weaker savings institutions stung by soured real estate loans will need help, Papadimitriou said. Italian banks probably are buying more of their country’s debt because they can sell it to retail customers who still have an appetite for the securities, he said.

Lenders in peripheral countries are facing pressure from regulators and the ECB to buy government debt, according to two executives and a banking supervisor who asked not to be identified because the discussions are private. German and French regulators, meanwhile, have said they asked banks to cut lending to those nations.

“As German banks reduce their exposure and the domestic banks pick up the slack, credit is becoming national again,” said Michael Dawson-Kropf, a Frankfurt-based senior director at Fitch Ratings. “But in most cases, like Ireland, there aren’t enough domestic deposits to do that, so they need external financing.”

‘Backdoor Exposure’

That’s when the ECB and other public lenders step in, creating a “backdoor exposure” for wealthier nations such as Germany, France and the Netherlands, said Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania.

“Private-sector banks offloading their obligations to the public sector doesn’t get the German taxpayer off the hook,” Egan said. His firm downgraded Germany’s sovereign credit to A+ in January, four levels below the top rating, amid worries that the country will have to rescue other EU nations.

Before the 2008 crisis, banks in Ireland held almost no Irish government debt. They owned about 20 percent of that nation’s sovereign bonds as of Dec. 31, according to data compiled by the Washington-based Institute of International Finance. In the meantime, the Irish government has pumped 62 billion euros into its banks to cover losses on real estate loans and now owns most of the banking system.

Tied at Hips

“The Irish government and the banks are tied at the hips,” said Constantin Gurdgiev, a finance lecturer at Trinity College in Dublin. “Banks get money from the government, which turns around and borrows from the banks. But how long can this game go on?”

Portuguese banks’ ownership of that country’s sovereign bonds jumped to 12 percent at the end of 2011 from 5 percent in 2007, according to IIF data. Spanish banks’ share of their government’s debt rose to 35 percent from 24 percent.

Meanwhile, foreign banks’ holdings of Spanish government debt dropped to 64 percent at the end of September from 74 percent a year earlier, IIF data show. In Ireland, the share declined to 23 percent from 27 percent, and in Portugal it fell to 19 percent from 26 percent.

‘National Fragmentation’

“This national fragmentation of credit is beginning to undo the financial integration that was one of the biggest benefits of the monetary union,” 

said Hung Tran, deputy managing director of the IIF, which represents more than 400 banks worldwide. “It’s not reducing the vulnerability of the banking system to the sovereign risk either.”

The ECB’s emergency-lending programs can provide indirect support for governments, “but only if sovereigns are perceived by markets to be going in the right direction,” David Mackie, chief European economist for JPMorgan Chase & Co., wrote in an April 10 note to investors.

“If there are doubts about the path ahead for sovereigns, then longer-term financing for banks will not necessarily provide much support as domestic banks may be reluctant to buy and other holders of sovereign debt may be keen to sell,” wrote Mackie, who is based in London.

Spain, Portugal, Italy, Ireland and Greece relied on banks in countries with stronger economies to finance their budget deficits for a long time, said Jan Hagen, a banking professor at Berlin’s European School of Management and Technology. With those lenders now weakened by losses and pressed to reduce risk, governments will struggle to finance themselves as the rest of the world stays away, he said.

“Governments loved the banking sector’s growth in the last two decades because they could borrow so easily,” Hagen said. “It was like a drug addiction. But like all addictions, it probably will end in a bad way.”