Saturday, November 19, 2011

Europe Fears a Credit Squeeze as Investors Sell Bond Holdings

November 18, 2011

Europe Fears a Credit Squeeze as Investors Sell Bond Holdings

Nervous investors around the globe are accelerating their exit from the debt of European governments and banks, increasing the risk of a credit squeeze that could set off a downward spiral.
Financial institutions are dumping their vast holdings of European government debt and spurning new bond issues by countries like Spain and Italy. And many have decided not to renew short-term loans to European banks, which are needed to finance day-to-day operations.
If this trend continues, it risks creating a vicious cycle of rising borrowing costs, deeper spending cuts and slowing growth, which is hard to get out of, especially as some European banks are having trouble meeting their financing needs.
“It’s a pretty terrible spiral,” said Peter R. Fisher, vice chairman of the asset manager BlackRock and a former senior Treasury official in the Clinton administration.
The pullback — which is increasing almost daily — is driven by worries that some European countries may not be able to fully repay their bond borrowings, which in turn would damage banks that own large amounts of those bonds. It also increases the already rising pressure on the European Central Bank to take more aggressive action.
On Friday, the bank’s new president, Mario Draghi, put the onus on European leaders to deploy the long-awaited euro zone bailout fund to resolve the crisis, implicitly rejecting calls for the European Central Bank to step up and become the region’s “lender of last resort.”
The flight from European sovereign debt and banks has spanned the globe. European institutions like the Royal Bank of Scotland and pension funds in the Netherlands have been heavy sellers in recent days. And earlier this month, Kokusai Asset Management in Japan unloaded nearly $1 billion in Italian debt.
At the same time, American institutions are pulling back on loans to even the sturdiest banks in Europe. When a $300 million certificate of deposit held by Vanguard’s $114 billion Prime Money Market Fund from Rabobank in the Netherlands came due on Nov. 9, Vanguard decided to let the loan expire and move the money out of Europe. Rabobank enjoys a AAA-credit rating and is considered one of the strongest banks in the world.
“There’s a real sensitivity to being in Europe,” said David Glocke, head of money market funds at Vanguard. “When the noise gets loud it’s better to watch from the sidelines rather than stay in the game. Even highly rated banks, such as Rabobank, I’m letting mature.”
The latest evidence that governments, too, are facing a buyers’ strike came Thursday, when a disappointing response to Spain’s latest 10-year bond offering allowed rates to climb to nearly 7 percent, a new record. A French bond auction also received a lukewarm response.
Traders said that fewer international buyers were stepping up at the auctions. The European Central Bank cannot buy directly from governments but is purchasing euro zone debt in the open market. Bond rates settled somewhat Friday, with Italian yields hovering at 6.6 percent and Spanish rates around 6.3 percent; each had been below 5 percent earlier this year.
For Spain, the recent rise in rates means having to spend an extra 1.8 billion euros ($2.4 billion) annually to borrow, rapidly narrowing the options of European leaders. For Italy, every 1 percent rise in rates translates to about 6 billion euros (about $8 billion) in extra costs annually, according to Barclays Capital.
If officials simply cut spending to pay the added interest costs, they face further economic contraction at home. If they ignore the bond market, however, they could find themselves unable to borrow and pay their bills.
Either situation risks choking off growth in Europe and threatens the stability of the Continent’s banks, which would further undermine demand and business confidence in the United States and around the world.
Experts say the cycle of anxiety, forced selling and surging borrowing costs is reminiscent of the months before the collapse of Lehman Brothers in 2008, when worries about subprime mortgages in the United States metastasized into a global market crisis.
Just as American policy makers assured the public then that the subprime problem could be contained, so European leaders thought until recently that the fiscal troubles of a small country like Greece would not spread.
But after the bankruptcy last month of MF Global, spurred by its exposure to $6.3 billion of European debt, other institutions have raced to purge their portfolios of similar investments.
“This is just a repeat of what we saw in 2008, when everyone wanted to see toxic assets off the banks’ balance sheets,” said Christian Stracke, the head of credit research for Pimco.
The European bond sell-off has been similarly sharp, accelerating in the third quarter, according to a research report by Goldman Sachs. European banks trimmed their exposure to Italy by more than 26 billion euros in the third quarter, for example. French banks like BNP Paribas and Société Générale, whose shares have been pounded lately because of their sovereign debt holdings, were among the biggest sellers.
Meanwhile, American banks have become skittish about lending to European institutions over similar concerns. Of the biggest banks that lend to Europe, about two-thirds have pulled back on lending to their European counterparts, according to the most recent survey of loan officers by the Federal Reserve.
American money market funds, long a key supplier of dollars to European banks through short-term loans, have also become nervous. Fund managers have cut their holdings of notes issued by euro zone banks by $261 billion from around its peak in May, a 54 percent drop, according to JPMorgan Chase research.
With borrowing costs ticking higher, more institutions have started selling their sovereign debt, creating a frenzy that forces bond prices to plunge and yields to rise at dizzying speeds, which begets even more selling. In the case of Italy, the yield on 10-year bonds spiked to current levels in a month, a huge move by government bond market standards.
The dynamic of falling bond prices also undermines the capital position of the banks, since they are among the biggest holders of government bonds in many countries. As those assets plunge in value, banks cut back on lending and hoard capital, increasing the likelihood of a recession.
In some cases, banks may even need to raise funds to shore up their financial positions. That was the case with UniCredit, Italy’s largest bank, which announced plans to raise 7.5 billion euros in capital earlier this week.
“The biggest risk everyone is talking about is whether Italy can continue to fund itself,” said Pavan Wadhwa, an interest rate strategist at JPMorgan in London. He said Italy had auctions Nov. 25 and 29. Any sign that it is unable to sell its debt to investors would be troubling, he said.
The prospect of slower growth across the Continent, and fears that budget deficits will balloon, is a major reason the selling has spread beyond Italian bonds to much stronger government borrowers with AAA credit ratings like France.
“You have to interfere with these cycles at as many places as possible,” said Lawrence H. Summers, President Obama’s former chief economic adviser. “There is nothing good to be said about being tentative.”
Graham Bowley and Liz Alderman contributed reporting.

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