Europe’s Banks Turned to Safe Bonds and Found Illusion

Bloomberg | Getty Images

Bank in Greece

As the bets that European banks made on United States mortgage investments went bust a few years ago, bankers piled into what they saw as a safe refuge: bonds issued by countries in Europe’s seemingly ironclad monetary union.

Now, the political and financial crisis engulfing the Continent has turned much of that European sovereign debt into the latest distressed asset, sending tremors through global financial markets not seen since the demise of the investment bank Lehman Brothers more than three years ago.

This week, shortly after European leaders formally conceded that Greece could not pay its debts and forced banks to accept losses, the shock waves reached Italy, the third-largest economy in the euro zone after France and Germany. And despite frantic efforts by politicians to contain the damage, market analysts said that France, one of the strongest countries in the euro zone, may soon feel the impact.

“When people started buying more European sovereign debt, there was not a cloud in the sky,” said Yannis Stournaras, director of the Foundation for Economic and Industrial Research, based in Athens. Now, he said, “This crisis is going to last because the perceptions of risk have changed dramatically.”

European banks face tens and possibly hundreds of billions of dollars in losses on loans to nations that use the euro. Worried about even greater losses if the crisis worsens, the banks have been scrambling to reduce their holdings of an investment that, like triple-A-rated subprime mortgage bonds, was once thought to be bulletproof.

The French bank Société Générale, for instance, this week marked down 333 million euros of its Greek sovereign debt holdings and in October slashed its exposure to that country to 575 million euros, from 2.4 billion euros at the beginning of 2011. Another French bank, BNP Paribas, has cut its holdings of Italian government debt 40 percent since July, to 12.2 billion euros.

How European sovereign debt became the new subprime is a story with many culprits, including governments that borrowed beyond their means, regulators who permitted banks to treat the bonds as risk-free and investors who for too long did not make much of a distinction between the bonds of troubled economies like Greece and Italy and those issued by the rock-solid Germany.

Banks had further incentive to overlook the perils of individual euro zone countries because of the fees they earned for underwriting sovereign debt sold to other investors. Since 2005, several dozen banks in Europe and the United States have earned $1.1 billion in fees from selling bonds for European governments, according to Thomson Reuters and Freeman Consulting Services.

Like other investors, banks clung for a long time to the seemingly inviolable belief that all the countries using the euro would make good on their debts. For years, Greek and Italian bonds did not pay much more than German ones, but banks were always hungry to chase even a fraction of additional profit. For much of the last decade, they bought the higher-yield bonds, ignoring the growing political and fiscal problems of those countries as well as other peripheral euro zone nations like Ireland, Spain and Portugal.

Regulators bear much of the responsibility. Before 1999, when Europe forged its monetary union, regulators permitted banks to treat as risk-free the debt of any country that belonged to the Organization for Economic Cooperation and Development, a club of developed nations that includes the United States and most of Europe.

“There was encouragement from European authorities for banks to load up on more debt, because it was seen as safe,” said Nicolas Véron, a senior fellow at Bruegel, a research firm in Brussels. “In hindsight, it was unwise risk management.”

Some regulators realized that allowing banks to set aside no capital for sovereign defaults could be a problem and moved to address it in a 2006 accord known as Basel 2. They mandated that big, complex banks use their own models to determine if individual countries were at risk and hold some capital against them. But the European Union never enforced the stiffer regime. And amid the subprime mortgage crisis, Europe’s regulators added to the problem by demanding that banks hold more safe assets, much of it sovereign debt.

As a result, banks were not discouraged from placing their most liquid assets “into the worst possible government debt,” Achim Kassow, a former Commerzbank board member, wrote in a study published by the European Parliament.

As losses mounted...

Now, Société Générale, Commerzbank and other banks cannot get rid of the shaky debt fast enough. In the last several months, they have booked billions of euros in losses from unloading it, although their exposure remains substantial. Including the effect of hedges, European banks had a net exposure of about $120 billion to Greek government borrowings and private debt at the end of June, according to the Bank for International Settlements. Even more worrisome, analysts say, is the banks’ exposure of $643 billion to Spain and $837 billion to Italy.

Banks in the United States are also caught in the crossfire. For Italy alone, they had $47 billion in net exposure to government borrowings and private debt at the end of June, the B.I.S. data show.

Goldman Sachs has $700 million in exposure to Italy, according to a regulatory filing released this week, and could feel the fallout if the bonds were marked down.

The loss from a write-down similar to that on the Greek debt — 50 cents on the dollar — would erase 10 percent of the $3.43 billion in profit Goldman earned in the first nine months of the year.

Regulators are requiring European banks to raise 106 billion euros in new capital by next summer to protect themselves against further losses.

Banks insist the risks are manageable. But the big fear is that they do not have enough capital to cover potential losses from the euro zone. That kind of crisis of confidence drove MF Global, the large New York brokerage firm, into bankruptcy last week after its $6.3 billion bet on European debt alarmed investors.

While the markets are now being brutally efficient in telegraphing the differing debt risks among European countries, they failed in that function for a long time, just as they failed to reflect the risks of subprime mortgage loans as a real estate bubble formed in the United States.

For most of the last decade, bond yields among Germany, Greece, Portugal, Ireland, Italy and Spain traveled in a tight pack. That meant investors buying and selling those bonds acted as if the countries were almost equally safe simply because they were members of the euro zone, despite shaky finances in Greece, real estate bubbles in Ireland and Spain and high debt in Italy.

The phenomenon rang alarm bells as far back as 2005, when banks, national treasuries and the European Commission held intense internal debates on why the spreads between Germany and other countries did not seem to reflect the differing risks, said a senior Brussels official involved with bank regulation.

When the subprime crisis started to buffet Wall Street in 2007, banks sought shelter by turning even more to European sovereign debt, especially countries with the best returns. The B.I.S. data show that bank lending to the governments of Portugal, Ireland, Italy, Greece and Spain, largely through bond purchases, rose faster than usual, by 24.2 percent, to $827 billion, between the second quarter of 2007 and the third quarter of 2009, when the crisis in Greece first started to taint European sovereign debt.

Banks across the world joined in this lending binge as they chased higher yields. Emblematic of those that took the plunge was Komercni Bank, a large bank in the Czech Republic that is majority-owned by Société Générale.

As the subprime crisis in America began mounting, Komercni veered into the seemingly safe Greek government bonds. The bank’s entire board, more than half of whom were long-time veterans of Société Générale, signed off on Greek debt purchases from 2006 through 2008. Now the bank is expected to write down an additional 2 billion koruna, or $111 million, on its Greek debt this year, after taking a 1.66 billion koruna hit in the second quarter. That is a manageable amount, but the bank would have been barely affected if it had bought the safer German bonds.

A spokesman for Société Générale refused requests for interviews with officials and declined to comment.

‘You guys should shut up, you’re selling our stuff.’

As the subprime crisis peaked on Wall Street, banks sharply increased their underwriting of European sovereign debt. In 2007, the world’s big banks made $113.9 million in underwriting fees; by 2009, that number had more than doubled to $273 million.

Société Générale went from issuing no Greek debt in 2005 to being the world’s eighth-largest underwriter just a year later. The bank has made $61.5 million in fees from underwriting debt for euro zone countries since 2005, according to Thomson Reuters. Deutsche Bank, the top underwriter of euro zone debt in that period, took in $87 million in fees.

Banks in the United States also profited. Since 2005, Goldman Sachs has earned $44.5 million in fees underwriting euro zone debt, and Morgan Stanley has earned $47.4 million, according to Thomson Reuters.

Their special relationship with governments sometimes also presented a unique dilemma: it gave banks little incentive to publicize red flags even if they were suspicious about sovereign debt.

In 2005, Marc Flandreau was a senior adviser in Paris at Lehman Brothers, one of several banks selling sovereign bonds for the French government. He suddenly wondered whether France’s finances were solid enough to merit the low interest rates at which it and the other members of the euro zone were selling their bonds. He wrote a memo to the French Treasury expressing his concerns.

“They went totally ballistic,” Mr. Flandreau recalled. “They said, ‘You guys should shut up, you’re selling our stuff.’ “

Benoît Coeuré, an official at France’s debt-issuing agency at the time, insisted that the policy was not to discourage the banks from analysis. But “if it had a negative tone on French policies,” he said bluntly, “my role was to object to it.”

Today, with Europe’s sovereign debt crisis seemingly spinning out of control, regulators are pressing governments and banks to divulge as much risk as they can and are asking banks to set aside billions of euros to protect against possible losses.

“Sovereign debt has lost its apparent risk-free status,” Hervé Hannoun, deputy director general of the Bank for International Settlements, said in a recent speech in which he called for an end to “the fiction.”

To restore confidence, he concluded, the world needs to move “from denial to recognition.”

Liz Alderman reported from Paris and Susanne Craig from New York.