Saturday, 12 November 2011

The European Sovereign Debt Problem

A syndicated newspaper story, "Euro zone sovereign debt is the new subprime," is the best telling of the current European bank problems that I've seen. Some excerpts:
PARIS — As the bets that European banks made on United States mortgage investments went bust a few years ago, bankers piled into what they saw as a safe refuge: bonds issued by countries in Europe’s seemingly ironclad monetary union.

Now, the political and financial crisis engulfing the Continent has turned much of that European sovereign debt into the latest distressed asset, sending tremors through global financial markets not seen since the demise of the investment bank Lehman Brothers more than three years ago.

This week, shortly after European leaders formally conceded that Greece could not pay its debts and forced banks to accept losses, the shock waves reached Italy, the third-largest economy in the euro zone after France and Germany. And despite frantic efforts by politicians to contain the damage, market analysts said that France, one of the strongest countries in the euro zone, may soon feel the impact.

“When people started buying more European sovereign debt, there was not a cloud in the sky,” said Yannis Stournaras, director of the Foundation for Economic and Industrial Research, based in Athens. Now, he said, “This crisis is going to last because the perceptions of risk have changed dramatically.”

European banks face tens and possibly hundreds of billions of dollars in losses on loans to nations that use the euro. Worried about even greater losses if the crisis worsens, the banks have been scrambling to reduce their holdings of an investment that, like triple-A-rated subprime mortgage bonds, was once thought to be bulletproof....

How European sovereign debt became the new subprime is a story with many culprits, including governments that borrowed beyond their means, regulators who permitted banks to treat the bonds as risk-free and investors who for too long did not make much of a distinction between the bonds of troubled economies like Greece and Italy and those issued by the rock-solid Germany....

Some regulators realized that allowing banks to set aside no capital for sovereign defaults could be a problem and moved to address it in a 2006 accord known as Basel 2. They mandated that big, complex banks use their own models to determine if individual countries were at risk and hold some capital against them. But the European Union never enforced the stiffer regime. And amid the subprime mortgage crisis, Europe’s regulators added to the problem by demanding that banks hold more safe assets, much of it sovereign debt.

As a result, banks were not discouraged from placing their most liquid assets “into the worst possible government debt,” Achim Kassow, a former Commerzbank board member, wrote in a study published by the European Parliament.

In what ways is this like the subprime debt crisis? Who is to blame?


  1. I think there are several fairly apparent parallels that can be drawn between the subprime mortgage crisis and the European sovereign debt problem. Weak regulation and investors who fail to look further into where they are putting their money. Furthermore, there is a lot of information asymmetry that can lead to problems, in this particular case, perhaps that Greece provided false information about its debt level and structure serves as a good example. While this article may read like opinion writing, it does bring up some intriguing points:

  2. The comparisons between Europe's crisis and the housing crisis in the US are fair. In each, the governments encouraged (if not demanded) poor investment. I think both economies experienced a slow learning curve as well, as they tried new investment plans at banks that turned out to be far less safe than originally thought.

    The problem in Europe is only bringing more attention to their spending and worker efficiency problems. When looking at countries that are still relatively safe from the crisis, and those that are being engulfed by liquidity problems, a dividing line lies on their productivity. Greece's workforce productivity pales in comparison to Euro zone countries like Germany and Belgium.

    One difference I think exists between the US and EU's problems is that in the EU there has been a safety net for all of these struggling countries. The US definitely paid for its crisis. Europe will pay as well, but considering how bad it could be, the IMF and ECB might be able to soften the blow. Additionally, Greece and Italy might have reacted quicker and more seriously had they not had the EU and the Euro to fall back on.

  3. Maximilian Roedder14 November 2011 at 12:05

    In my opinion, the European governments have to take the blame for the crisis they now face.
    In order to finance the increasingly high expenses to finance the social security systems they had to issue more and more debt. However, they wanted to keep their cost of borrowing as low as possible and, therefore, put regulations in place that made government debt a very liquid and presumably risk free asset.
    This is comparable to the political will in the U.S. to enable most American citizens to own their own house. Just like this political will lead to the most absurd consequences the political will in Europe lead to a big bubble as well.

  4. The European crisis has parallels to the sub-prime mortgage crisis. Both seemed to have stemmed from people riding a bubble that would eventually burst. As well, banks participating in more off balance sheet activities always brings about more risk, and higher default probability.

    Greece is not to blame for this crisis, but just happens to be the first country seriously struggling. Since they are requiring the rest of the countries to bail them out, it is now looking like the European central bank will need to increase their discount loan window (parallels to the Fed reserve.)

  5. I think that the European governments are to blame. It is similar to the mortgage situations that occur in the US.

  6. The rating agencies should take the blame in this situation. According to our reading the government debt of Greece has a risk weighting of 0%. I'm not certain if the rating agencies make this distinction, however, if agencies like S&P or Moody's are going to continue to hold high ratings on insolvent firms/countries they should take more of the blame. The rating agencies could easily be taking bribes from the government here, which in that case both parties are to blame.

  7. I agree with the article in that there are several parties that have contributed to this disastrous situation. The goverment was over-extending itself and investors weren't using proper discernment.

    Additionally, economic experts should have recognized the parallels between the 2008 financial crisis in the United States and what is taking place in Europe currently. Those that did and tried to act through the creation of Basel 2 in 2006 should have persisted and worked more closely with regulators to develop a concrete plan of prevention.

    If the world learned one thing from the 2008 crisis, it was that nothing is "foolproof". Purchasing European sovereign debt to remedy losses from collapsed mortgage investments appears to be no exception to this rule.

  8. Well, I have some personal bias here because when Italy joined the Euro I remember from one summer to the next prices doubled. What I mean by this is that Germany, and France really wanted the Euro, and they persuaded countries that were maybe not economically ready or could have used five or ten more years to join the Euro or face interest rate penalties of 5-6% of GDP.

    I think with Greece we are seeing the aftermath of what was undoubtedly a country who's economy just couldn't sustain the Euro, and be as productive as Germany and France. It is appalling to me that after being lured into the Euro by the big european powers, these same countries are unwilling to help Greece.

  9. The main issue is that the Eurozone is a monetary union without a fiscal union. As the article points out, once the Euro went into effect, interest rates on sovereign debt converged. It makes no sense that German and Greek bonds were yielding the same returns, despite the clear differences in risk. Investors and bankers were over confident in the monetary union, despite the huge differences in domestic fiscal policies. The changing interest rates encouraged countries such as Greece and Portugal to borrow significantly beyond their means. In this way it is very similar to the subprime mortgage crisis that has affected the United States. Whereas housing bubbles did occur in Spain and Ireland (like in the US), borrowing and government spending far exceeded practical levels in Greece due to lax lending policies. There is no one person/group to blame, but I would point the finger at the EU countries that allowed countries such as Greece to join the Eurozone despite not meeting the strict criteria of the Maastricht Treaty.

  10. The common thing is that the public lose confidence after some so-called AAA or heaven-safe assets turn out to be dangerous. Specifically, the market overreacts to be extremely risk-averse after tragedies of Greek sovereign debt and MBS. Just like a bank run, some of the solvent debt issuers are facing increased financing cost and may become insolvent. Information asymmetry about which governments are able to pay off debts leads to a similar "debt run" game for investors. No single party should be responsible for the whole crisis. But in term of losing confidence, rating agencies are the first to blame. They failed to do a fair job. In US MBS crisis, they weren't capable to price sophisticated derivatives and gave out irresponsible AAA ratings. In European debt crisis, they didn't notice the trick played but Greece and Goldman Sachs.

  11. I think that the government and the rating agencies are the groups to be blamed in this situation. Rating agencies made incorrect ratings of firms and countries and the government should've corrected or regulated in the right way. The European sovereign debt problem is similar with the U.S. sub-prime mortgage crisis in 2008 where the rating agencies didn't do a good job of rating.

  12. The people in some European countries try to get the social welfare that doesn't match their productivity,i.e.they don't deserve. Just like in the U.S. where people who shouldn't have got a house actually got one, even more than one. The governments should be to blame for this. They are too short-sighted. As with the spread of the crisis, it's similar to the scenario in which a small portion of food has been tainted with lethal virus and dispatched to people. Because no one knows where the virus is, no one dares eating the food, leaving even the safe parts decay.

  13. Good comments! One oddity, Josh, is that the Basel treatment of sovereign debt as riskfree is not something to blame on the rating agencies. Apparently, even if Greece has a CCC rating, the Basel rules still treat its debt as riskfree. Also, if the rating agencies are doing their job, their rating of Greek debt should depend on the probability of a bailout. From the point of view of the investor, there is no difference between being paid interst on their Greek bonds by the Greek government or by the German government.