Why Does the Pain in Spain Fall Mainly on the EU Plain?

Yesterday, I wrote about U.S. exposure —or the broad lack of U.S. exposure—to Spanish sovereign debt.

(I picked up on Tracy Alloway's piece in the Financial Times Alphaville blog, which commented on a new report out from Goldman Sachs , regarding the national distribution of eurozone debt among investors.)

From my piece yesterday: "According to the Goldman report: 'US holdings of Spanish debt securities were particularly small, accounting only for about $26 billion or 2.5 percent of all foreign holdings.' To put that number in perspective, 'That’s about a tenth of France’s holdings, which stood at 24.5 percent or $252 billion.' Calculated by GDP, the French economy is only about 20 percent as large as the U.S. economy. So that means, on a GDP basis, France has invested in Spanish debt at a rate fifty times higher than the U.S."

So we know that U.S. holdings of Spanish sovereign debt are rather small.

Today we ask why.

If you had to speculate about reason for the limited exposure of U.S., you could do worse than to select the following: Bank capital reserve requirements.

As I wrote last week:

"Banks in euro zone countries have not been required to hold back any capital as a hedge against bonds issued by the governments of euro zone nations."

And then, in reference to what happened next:

"But reality has intervened. First Greece, then Ireland, received massive bailout packages. The danger of imminent sovereign default was real. The notion that such instruments could be treated as 'risk-free' proved to be a fantasy."

"'Risk Free' may have been a lovely idea. Like a world without war. Or the dissolution of national borders, as a grand utopian marketplace sprung forth from the soil that had hosted some the 20th Century's worst nightmares."

"The language may seem abstract—but the results were very concrete."

I went on to quote a research paper, written for the European Parliament, by Achim Kassow of the German Commerzbank: "The fixed risk weight of zero percent ... has, in our view, played a direct role in the excessive build up of low-quality sovereign debt in bank portfolios as well as of high levels of debt in certain sovereigns."

And, from Graham Bishop, a former investment banker, now a consultant to the European Union: "Is it right that the regulatory framework governing all types of financial institution in the EU should continue with the fiction that debts of EU-penalized governments are risk- free?"

And so on.

The Goldman report goes on to say "We find that—anecdotally, at least—non-European investors often have the most pessimistic views with regards to the prospects for the peripheral economies."

Perhaps the source of that anecdotal pessimism is simply this: The reality of risk weighted return—net of reserve requirements.

I wrote a brief, simplified example of this phenomenonlast month, as the storm clouds began to gather in Europe

I wrote then: "Classifying a bond with a 'zero risk' weighting means that a bank doesn't have to set aside additional capital when holding a bond. As you might imagine, setting aside capital effectively decreases the rate of return on asset."

"For example, imagine that you own a total $200,000 worth of bonds.

Now imagine that half the bonds you own are issued by Country A, and half the bonds you own are issued by Country B. In this example, let's say you own equal amounts of both bonds: $100,000 worth of Country A's bonds, and $100,000 worth of Country B's bonds. Both bonds pay an identical five percent interest. If you had to set aside a 20 percent capital cushion for bond B but not for bond A, you'd only be earning five percent interest on $80,000 in principal—which would dramatically lower your yield on Bond B."

Former Speaker of the House Tip O'Neil is best remembered for his droll observation that all politics is local.

All regulation is local as well.

Even in a globalized world—where investors are chasing yield across the planet.

If you're the person charged with making investment decisions for a fixed income portfolio, you only care about the rules and constraints within your own regulatory jurisdiction.

Talking heads can discuss the theoretical implications of globalization ad nauseum.

But back in the real world, bankers only care about effective yield—and risk.

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