LARGE BANKS IN EUROPE STRUGGLE WITH WEAK BONDS / THE NEW YORK TIMES ( HIGHLY RECOMMENDED READING )

August 3, 2011

Large Banks in Europe Struggle With Weak Bonds

By LANDON THOMAS Jr.


LONDON — Ever since the European debt crisis began, the risk of contagion — of problems spreading from smaller countries to bigger ones, like Italy and Spain — has worried government officials and investors.


Now, another type of contagion is causing concern: the risk of problems spreading to big banks, especially in Italy and Spain.


The growing vulnerability of the giant banks in these two countries is spurring investor fears that Europe’s latest bid to get a handle on its festering debt crisis, adopted just a few weeks ago, has come up short.


The banks own so many bonds issued by their home countries that they are being weakened as the value of those bonds falls, amid concerns that the cost of government borrowing could become too expensive for Italy and Spain to bear.


Now there are signs that these concerns are, in turn, making it harder and costlier for the banks to borrow money to finance their day-to-day operations, a troubling trend that, at the worst, could lead to liquidity problems.


Since Europe’s second major rescue package was announced last month — aimed as much at calming fears over Spain and Italy as providing funds to Greece — the yields on Spanish and Italian bonds have hit more than 6 percent, sharply higher than they were paying on new borrowings just a couple of months ago.


In doing so they have entered what analysts refer to as the “danger zone” for 10-year bond yields, with the cost of government borrowing so high that investors become unnerved, as was the case with bailed-out Greece, Portugal and Ireland.


Bearing the immediate brunt of this development are regional banking heavyweights such as UniCredit in Italy and Santander and BBVA in Spain, which traditionally have been reliable financing machines to their home governments and as a result are now saddled with large bond holdings that are losing value by the day.


Many of these banks hold domestic bond portfolios that exceed their capital levels.


According to a report issued on Wednesday by Sanford Bernstein, a research firm, UniCredit’s exposure to mostly Italian bonds is 121 percent of its core capital ratio. For Intesa, a less-diversified competitor, that figure rises to 175 percent. For Spain, the ratios are no less daunting: a startling 193 percent for BBVA, Spain’s second-largest bank, and a less alarming 76 percent for the global banking giant Santander.


As a result, the markets have begun to focus on a number of warning signs that some European banks are finding it harder to meet their funding needs, especially in dollars.


They are borrowing larger amounts directly from the European Central Bank in its weekly lending operations, suggesting they can’t find all the money they need from the private sector to keep themselves going.


Some analysts said perhaps most worrying was that the rate it costs European banks to borrow dollars in the open foreign exchange market, by swapping their holdings of euros, has shot up twofold in the past few days — still far below the levels seen in 2008 when the market virtually froze but the highest since May 2010 when the European debt crisis first started to intensify.


Recent write-offs by French banks over their own Greek bond holdings have compounded fears over the health of Europe’s banks.


“I don’t think anyone wants to be long European banks right now,” said Simon White, an analyst and partner at Variant Perception, a London-based research firm.


UniCredit, Italy’s largest lender, reported better-than-expected second-quarter earnings on Wednesday and in a conference call, the bank’s chief executive said it had completed 83 percent of its borrowing needs for the year.


Nevertheless, that profit snapshot does not fully take into account the steep rise in Italian government bonds, from about 4.6 percent in early June to just over 6 percent now, which means that the value of those bonds has fallen.


Even more worrying is the fact that the European Financial Stability Facility, Europe’s so-called bazooka rescue fund that it endowed last month with the powers to recapitalize weak banks, will not be able to offer any such aid for at least two months.


According to a stability fund official, staff members there are working night and day to recast the entity, but do not expect to be finished until the end of August. At that point, it must be approved by the parliaments of the 17 countries that use the euro currency.

Only then could it go to the market and raise funds to help a bank in need.

That may well be too late.

As investors flee Spanish and Italian government bonds, these huge bond holdings have become a significant millstone on their countries’ banks — curbing their ability to lend and, consequently, heightening the prospect of a double-dip recession in Italy and Spain, two of the euro zone’s slowest-growing economies.


Despite their best efforts to deleverage, all these banks have loans that significantly exceed their deposits. 

Standard banking practice has been for these banks to put up as collateral their home market government bonds, which in the past were seen as liquid, risk-free investments — much like United States Treasuries.


If, as was the case with Ireland and Greece, lenders stop accepting these bonds or start demanding more of the bonds to reflect their lower value, these banks may no longer be able to access the day-to-day financing that is their life blood. This is what happened during the crisis in the fall of 2008, when banks stopped lending to one another, causing markets to seize up — and leading the government to bail them out or risk the weakest banks failing.

“You could have a C.F.O. of a lending bank say, ‘Look, I just do not want to take this credit risk,’ ” said Marcello Zanardo, a European Bank analyst at Sanford Bernstein. “We are not there yet — but it is not impossible to get there.”


What is worrying many bank analysts — and surely the banks themselves — is that, in an investor panic, one might get there sooner rather than later.

One possibility is that LCH.Clearnet, the London clearing entity that in a transaction between two banks or other counterparties assumes the risk if the trade fails, may begin to demand more collateral if these securities continue to lose value.


That would mean that an Italian or Spanish bank putting up a government bond to back a short-term loan or repurchase agreement would see that bond marked down by its clearer, forcing it to put up more bonds — or accept less cash to fund its operations.


According to LCH, once the spread between, say, a Spanish or Italian government bond and a benchmark AAA bond index surpasses 4.5 percent, the issuer is liable for a trimming. At that point, the borrower is forced to put up more government bonds as security, and if the spread continues to widen is ultimately forced out of the market.


But in some cases, demands for more collateral are already being imposed. According to one London-based banker, who declined to be identified, LCH has already begun to require large Spanish banks to put up more bonds to cover transactions.


Such was the case earlier with Greek, Irish and Portuguese banks. Exiled from the interbank market — in which banks lend to each other — they were forced to turn to the European Central Bank to satisfy their pressing requirements. So far, Italian and Spanish banks have made minimal use of the central bank’s emergency financing facility.


If this trend continues, Merrill Lynch wrote in a report on Wednesday, it “would have a very significant impact not only on Spanish spreads but also on the level of interbank stress. Resulting in full contagion within the euro zone.”


Graham Bowley contributed reporting from New York.