BANK INVESTORS FEAR RETURN OF EUROPEAN DOOM LOOP / THE WALL STREET JOURNAL

Bank Investors Fear Return of European Doom Loop

Political risks loom large again and bond markets take the hit

By Paul J. Davies


PREMIUM RISKS
Annual cost to protect €10 million of banks' senior bonds against default over fiveyears

Source: IHS Markit

When European politics get volatile, eurozone banks feel the chill.

The collapse in Italy of attempts to form a populist government over the weekend led to a nasty sell-off in Italian government bonds and European bank stocks broadly on Monday and Tuesday. 
But even worse has been the reaction of investors in banks’ bonds. This matters because it feeds directly into the cost of funding for banks and the lending they can supply to the wider economy.
One way to measure this reaction is in the cost of protecting banks’ debt against default in derivatives markets. This cost has shot up in recent days not only for Italian banks, but also banks in Spain, France and Germany.


The cost of protection on the index of European bank debt--the iTraxx senior financials--was 20% higher on Tuesday morning, according to IHS Markit , a data provider. That is worse than the performance of bank stocks: the Stoxx Europe 600 Banks index lost about 3%, according to FactSet.

For UniCredit and Intesa Sanpaolo , Italy’s two biggest banks, the cost to protect against default has more than doubled in the past two weeks, according to IHS Markit, with the biggest rises coming Tuesday. Spain’s Banco Santander is enduring a similar ride.


DOOM LOOP
Bank exposure to government bonds as a share of total assets by country

Source: European Central Bank

Among French banks, which saw a sharp spike in early trading, investors were likely looking for a cheap and readily tradable hedge against the extreme risk of a Eurozone breakup. With Italian and Spanish banks, which have been hardest hit, there are real risks on their balance sheets: a hefty exposure to their own government’s debt.
As government bonds are sold and drop in value that is a hit to profits for these banks. It is also an unwelcome reminder of the “doom loop”, the vicious spiral of previous crises in which debt-laden eurozone governments both hurt national banks’ profitability and are too weak to stand behind them.




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The Intesa Sanpaolo trademark is shown on the historical headquarter of the bank in Turin. Photo: marco bertorello/Agence France-Presse/Getty Images 


In Italy, government bondholdings are nearly 11% of bank assets, in Spain they are more than 9%, while in France and Germany they are just 2.2% and 3.6% respectively. These figures from the European Central Bank cover all government bondholdings, but national domestic bonds tend to make up the vast majority of what banks own.

Investors are fearful that banks once again get dragged down by political decision making that further weakens individual countries’ financial positions or threatens their membership of the euro. That would likely mean economic pain and rising bad loans.

Italy is a long way from turning its back on the eurozone, but bank bond investors and shareholders aren’t ready to show its politicians much patience.