International talks are continuing in Washington this week on the periphery of International Monetary Fund and World Bank meetings over how to avoid a default by Greece as early as next month.
The global threat posed by government bonds has been magnified, ironically, by the decision of European regulators that these bonds could be considered risk-free.
In according this special status to government bonds, regulators across much of the continent have allowed banks to buy them without setting aside any money as a buffer against possible losses, which would be required for most other loans. Freed of this cost, banks have been willing to lend governments money at lower interest rates.
The risk-free rule was initially adopted by bank regulators in individual countries, with banks in France, for instance, allowed to buy French government bonds at risk-free prices.
But after the creation of the euro zone a decade ago, the rule was generalized across all the countries that shared the currency. So today, banks in any of the 17 countries in the euro zone can treat any bond issued by a euro-zone government as risk-free, regardless of whether the issuer is solid like Germany or shaky like Greece.
Before the euro zone, individual countries issued bonds in their local currency and could print more of it, whether it be francs, lire or drachmas, if a crisis was making it difficult to pay off the loans.
Today, with the European Central Bank in charge of euros, governments in Athens, Rome and elsewhere no longer control the “printing press.” Yet even as individual governments lost the power to pay off debts by printing money, the politics and regulations of the euro zone encouraged banks, insurance companies and other financial firms to load up on government bonds — and countries to issue them.
The “persistence in sustaining risk-free status . . . has, in our view, directly contributed to the development and severity of recent market turmoil,” Achim Kassow, a member of the board of managing directors of Germany’s Commerzbank, wrote in a recent study of the bank rule for the European Parliament. “Both the course and the severity of the crisis can clearly be tied to incentives set by current regulation.”
There are parallels to the U.S. experience leading up to the mortgage meltdown that began four years ago. Mortgage finance giants Fannie Mae and Freddie Mac used their AAA credit ratings and implicit guarantee from the federal government to borrow money at artificially attractive prices. Investors, considering them a low risk, were eager to lend them money. In turn, Fannie and Freddie bought more and more mortgages, including many that were considered sound but were actually risky.
The hazard posed by the companies’ artificially low borrowing costs was driven home when homeowners stopped paying their mortgages. Both the companies and the investors took a huge hit — as did the wider economy.
Europe faces a similar danger.
The different risks of Greek vs., say, German bonds was not fully acknowledged until the combination of rising debt and slow economic growth made it apparent in the fall of 2009 that Greece would have trouble paying back all that it had borrowed. Because Greece could not escape from the predicament by printing its own money, investors began treating it like an ordinary, nongovernment borrower and demanding much higher interest rates, researchers at Morgan Stanley wrote in a recent analysis.
Those concerns spread across Europe as more governments came under the same microscope, unsettling the region’s economy.
To many, including some of the euro area’s political founders, the risk-free rule is an example of how Europe’s troubles are largely self-inflicted, the result of trying to reap the benefits of a common currency without making tough political choices over issues such as public debt and centralized control over national budgets.
Olli Rehn, European economic and monetary affairs commissioner, said Thursday that Europe never had its “Hamiltonian moment,” referring to the point in U.S. financial history when the debts of the states were assumed by the new federal government.
According to European officials, there was an initial hope when the euro zone was created that market discipline and the oversight provided by organizations such as the European Commission would keep Europe’s finances from running off the rails. But the commission’s oversight proved to be weak.
Meanwhile, the declaration by the European Commission and national bank regulators that government bonds carried no “risk weight” sent a signal that bonds issued by euro-area governments were sure to be repaid.
In little more than a decade, banks in France and Germany have larded up on the bonds of Greece, Portugal, Italy and other countries whose ability to repay has been called into question — putting the banks themselves at risk.
Greece, Portugal and Ireland have sought emergency help over the past year after their borrowing costs rose to unsustainable levels. Three other nations — Spain, Italy and Belgium — are facing increased borrowing costs as well. All told, roughly half of Europe’s $9 trillion in outstanding debt is under what the IMF considers “heightened credit risk.”
Risks to banks
The threat facing European banks is especially grave because they have not set aside capital to cover losses on the bonds, prompting financial analysts to worry about the overall health of the European banking system. If governments do default, banks may not have enough capital to absorb the losses, and the failure of one or two firms could trigger a global credit meltdown, like the one caused by the failure of Wall Street investment bank Lehman Brothers in 2008.
The IMF on Wednesday examined the rising probability that bonds issued by Greece and the five other high-risk countries may not be worth their face value. The agency estimated that European banks faced roughly $400 billion in losses because of their bond holdings. That figure represents a substantial proportion of the capital that banks set aside for possible losses on all loans they have made to both public and private borrowers.
Europe’s debt problems are not rooted only in the risk-free rule. While cheap money was widely available, some governments were more profligate in spending than others, and not all in the euro zone have got into trouble.
The European Central Bank also played a role by keeping benchmark interest rates low, even as real estate bubbles inflated in Spain and Ireland and as Greece spent excessively on public benefits. The ECB was also willing to accept government bonds of any euro-area nation as collateral in return for making loans to banks, regardless of whether bonds were a good investment. This, in turn, gave banks even more reason to increase their demand for government bonds.
But it would be difficult politically for European regulators to start drawing distinctions that favor one European nation’s bonds over another.
“Is the European Central Bank going to say, ‘I like this bond but not that bond’? How can you do that in a currency union?” said Nicolas Veron, an analyst at the Peterson Institute for International Economics. The current policy “isn’t right, but it is not surprising they went for it.”