Euro zone sovereign debt is the new subprime

Sydney Morning Herald

When analysts began expressing concerns about supposedly risk-free European bonds, they were told to keep quiet, write Liz Alderman and Susanne Craig in Paris.

As the bets that European banks made on US 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 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 AAA-rated subprime mortgage bonds, was once thought to be bulletproof.

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.

Now, Societe Generale, 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 $US120 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 $US643 billion to Spain and $US837 billion to Italy.

US banks are also caught in the crossfire. For Italy alone, they had $US47 billion in net exposure to government borrowings and private debt at the end of June, the Bank for International Settlements data show.

Goldman Sachs has $US700 million in exposure to Italy, according to a regulatory filing released this week, and could feel the fallout if the bonds were marked down.

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 Bank for International Settlements 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 per cent, to $US827 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.

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,'' Herve 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''.

Cited only in part as it is a lengthy article, but an interesting chronicle of the banking industry migration of debt holdings over the past four years, as it sought to escape the US subprime crisis and invest in Europe and now faces a similar problem with holdings of Eurozone sovereign debt. What I really wonder is, will this develop into another banking crisis of huge significance as it did back in 2008 as sovereign debt risk spreads from one Euro country to another? Could this lead to another Lehman event where governments or central banks will have their hand forced to intervene to rescue any TBTF banks or sovereigns? Will there be capacity of governments and central banks to contain such another event? Or will the only option in the end be to sit back and watch the entire system crumble? I really don't know of course, but I do entertain the possibility that should the Euro situation spin out of control, and contagion spreads from country to country, bank to bank, that there will be little if anything that can be done to rescue it.

Can anyone see a trend here? Can anyone see a permanent solution to the Eurozone crisis? Consider further the following:

Will Italy tip Europe over the edge?

The problem with Italy is that it is so much bigger than the other euro-zone countries that have fallen so far. Plus, if it goes, it is likely to take France with it, leaving a hugely reluctant Germany to support them all.

Italy has the world's third-largest bond market and more government debt than the other problem euro-zone countries combined. France is joined at the hip with Italy because French banks have swags of this Italian debt - about €300 billion ($A403 billion) worth. That's twice the entire debt held by the Australian government at risk in France. The French were big lenders to Greece too, and that's why there is now so much speculation France could be the next to teeter. There are growing signs the end could be near for the euro zone, with reports at the weekend that France is leading talks to form a breakaway region by jettisoning the bad eggs. British newspapers are reporting that the Bank of England has made preparations for European armageddon.

The signs of a workable solution for the euro zone are not good, says Dr Oliver. ''It's been one step forward, two steps back in Europe for quite some time now,'' he says. ''That a relatively minor problem in Greece 18 months to two years ago has managed to spiral into this debacle says it all.'

So what was a relatively minor problem some two years ago, or even no problem prior to that as per the OP, we now have a situation that has escalated with adverse impacts on the much larger Eurozone economies. What could of feasibly been more easily managed two years ago has now grown into a far bigger convoluted problem where a permanent solution is becoming increasingly unlikely. This isn't fear mongering, this is just the reality of the situation. The hole could of been far more easily plugged two years ago (or maybe not, perhaps it was just inevitable that it would all crash and burn anyway), but now that debt has grown and with it, so has the risk and costs of insuring those debts. Thus a workable solution is not looking too good.

Can anyone see a trend here? Can anyone see a permanent solution to the Eurozone crisis? Consider further the following:

Will Italy tip Europe over the edge?

The problem with Italy is that it is so much bigger than the other euro-zone countries that have fallen so far. Plus, if it goes, it is likely to take France with it, leaving a hugely reluctant Germany to support them all.

Italy has the world's third-largest bond market and more government debt than the other problem euro-zone countries combined. France is joined at the hip with Italy because French banks have swags of this Italian debt - about €300 billion ($A403 billion) worth. That's twice the entire debt held by the Australian government at risk in France. The French were big lenders to Greece too, and that's why there is now so much speculation France could be the next to teeter. There are growing signs the end could be near for the euro zone, with reports at the weekend that France is leading talks to form a breakaway region by jettisoning the bad eggs. British newspapers are reporting that the Bank of England has made preparations for European armageddon.

The signs of a workable solution for the euro zone are not good, says Dr Oliver. ''It's been one step forward, two steps back in Europe for quite some time now,'' he says. ''That a relatively minor problem in Greece 18 months to two years ago has managed to spiral into this debacle says it all.'

So what was a relatively minor problem some two years ago, or even no problem prior to that as per the OP, we now have a situation that has escalated with adverse impacts on the much larger Eurozone economies. What could of feasibly been more easily managed two years ago has now grown into a far bigger convoluted problem where a permanent solution is becoming increasingly unlikely. This isn't fear mongering, this is just the reality of the situation. The hole could of been far more easily plugged two years ago (or maybe not, perhaps it was just inevitable that it would all crash and burn anyway), but now that debt has grown and with it, so has the risk and costs of insuring those debts. Thus a workable solution is not looking too good.