Saturday, November 19, 2011

Regulators as source of financial instability: lenders flee Eurozone debt

As this blog has previously predicted, the result of the financial regulators' requiring Eurozone banks to hit a meaningless 9% Tier 1 capital ratio is to trigger a downward spiral in demand for Eurozone loans or bonds.

As these banks sell assets to reduce their leverage, it compounds the problems caused by the buyer's strike by non-Eurozone investors for Eurozone loans and government bonds.

A NY Times article confirms and documents this 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.... 
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.... 
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.
Banks cannot tell which of their peers are solvent and which are insolvent.
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....

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