Warning lights blink as banks in Spain and Italy load up on sovereign debt


While national borrowing costs may dip, new risks arise over bank-government links, writes LIZ ALDERMAN

ONLY A few months ago, banks around the world were scrambling to sell piles of European government bonds that had turned toxic as the Continent’s sovereign debt crisis flared.

While the fear has eased since then, warning lights are blinking again in Spain and Italy – the two countries considered most susceptible to a second round of problems – amid signs that banks there are once more loading up on the sovereign debt of their governments.

New data shows that Spanish and Italian banks have been buying such debt in record amounts after the European Central Bank lent financial institutions billions in cheap money over the winter in the hopes that banks would buy more bonds from their own government to tamp down national borrowing costs, which had earlier shot toward the high levels that forced Greece to take a bailout.

From November to February, during which time the central bank lent more than €1 trillion to 800 European banks, Spanish banks increased their holdings of government securities by €68 billion and Italian banks by €54 billion, both buying, in particular, debt from their own countries.

But while the purchases pushed down national borrowing costs, and have so far helped Spain and Italy avoid asking for a financial lifeline as Greece did, the effect has been to raise new risks by tying the health of the banks to the fate of their governments.

The action has caught the attention of analysts. Last week, a number of banks, including Société Générale, Barclays and Credit Suisse, telegraphed their concerns. In a note to clients, SocGen said the connection “between bank risk and sovereign risk has increased”. As Spain and Italy grapple with downturns amid deep spending cuts and tax increases intended to cut high deficits, “a further deterioration of the fundamental news would prove particularly toxic, now that banks have increased their exposure”, the note said.

Spain is moving most quickly out of the eye of the storm. With unemployment near 23 per cent, and youth unemployment at 50 per cent, the government of prime minister Mariano Rajoy faces challenges after he introduced sharp budgetary cuts. The country is facing its second deep recession in three years. At the same time, banks are not lending much into the broader economy. “Banks are lending to their governments, but not apparently to businesses,” Credit Suisse said in a note.

Spanish banks are already holding loads of troubled mortgages after the nation’s housing boom went bust. While government bond holdings make up only 6 to 7 per cent of Italian and Spanish banks’ balance sheets – down from 8 per cent a decade ago – risk could swirl again if investors believe the crisis may get a second wind.

Laurent Fransolet, head of European fixed-income strategy at Barclays Capital, said investor sentiment had become more fragile and could deteriorate quickly. Markets are shedding the optimism of the last couple of months, he said.

Stocks in Europe and on Wall Street fell late last week amid renewed concern about Europe’s debt crisis as Spain failed to find buyers for about a quarter of its 10-year bond offering last week. Yields on the bonds jumped to 5.86 per cent, fanned also by concerns that a new austerity programme may hobble the economy. They had fallen to as low as 4.6 per cent in January, when banks used the cheap central bank loans to buy up government bonds. But domestic banks will not buy nearly as many sovereign bonds when the ECB’s lending programme stops. The Federal Reserve and the Bank of England, which flooded their banks and markets last year with cheap cash to stabilise the upheaval from Europe, are also trying to wean financial institutions off those funds.

Foreign investors – whether the Chinese government or overseas banks – have stayed away recently from Italian and Spanish bonds. Banks in France and Germany are also thought to be buying, though not large amounts. While both countries have already sold most of the bonds they had printed for the year, the question is who will buy when more are issued.

Further episodes like the bobbled Spanish bond auction could deepen fears about the country and send yields yet higher, though perhaps not above the 6.7 per cent Spain paid at the height of the crisis. Should that happen, problems would ripple again through Italian and Spanish banks and in Europe’s banking sector, even among banks that shed billion of euros’ worth of Italian and Spanish debt but still hold some on their books.

“It’s definitely concerning,” Michelle Bradley, an analyst on the European interest rate strategy team at Credit Suisse in London, said of the government bond holdings concentrated in Spanish and Italian bank coffers. In Greece, most banks were relatively sound. “In Greece, it was government troubles that passed through the banking sector, rather than the other way around,” Bradley said. As the link between the governments and their banking sector strengthens, so do the worries. “We’ve seen through the crisis that this has been negative,” Bradley said. – (New York Times service)