Europes debt crisis

Rushing for the exits

A scramble is under way to reverse the run on Italian bonds
Nov 12th 2011 | from the print edition

THE moment when a throng of peacefully moving people turns into a panicked herd is difficult to predict. Yet, once triggered, it is almost impossible to calm the hysteria. In financial markets too, it is better to avert panic than to try to pacify it. On Italys bond market, the worlds third-largest, where yields had been rising for weeks, fear turned to panic early on November 9th. Risk officers at LCH.Clearnet, which stands between banks trading in bonds, said that its members would have to post much higher margins against their holdings of Italian government bonds. This was intended to protect the clearing house by reducing the risks posed by banks trading Italian government bonds, given the wild swings in their prices over the past few months. Yet this technical change to a part of the financial system that most people have never heard of had the same effect as shouting Fire! in a crowded theatre. Almost at a stroke banks trading Italian government bonds, or using them as collateral for other transactions, would have either had to come up with billions of euros in extra cash or would have quickly had to sell some of their holdings. Within minutes of the market opening there was a fully fledged run on Italian government bonds. Buyers were hard to find, and in thin markets yields on the bonds jumped past 7% before stabilising just below 7.5% on what traders assumed was buying by the European Central Bank. The clearing platforms have no option but to protect their members and in doing so, they will inevitably turn the screw on Italian government bond markets and push yields closer to levels which could potentially trigger a death spiral, wrote Don Smith of ICAP, which helps dealers trade. The margin increase was not entirely unexpected. Over the past year the clearing house asked for more margin on Portuguese and Irish bonds after their prices fell sharply. Yet the increase on Italian debt came sooner than expected, as it was triggered before Italian bonds crossed a threshold that the clearing house was thought to use (4.5 percentage points above the average interest rate of AAA-rated government bonds in the euro zone). And the margin increase is unlikely to be reversed, even if ECB buying drives yields back. The triggering of margin calls has changed investors perceptions of Italian government bonds and will worsen the governments funding position. The immediate risk is that banks which might have held Italian bonds as part of their liquidity reserves or the building blocks of other financial products are dumping them for safer bets, such as German Bunds. There is a reason why Bund yields are approaching 200-year lows, says Hans Lorenzen of Citigroup, a bank. Everyone is trying to crowd into the same trade. Among the large European banks that are dumping Italian bonds are BNP Paribas and Commerzbank. It is what the market is asking us to do, says one banker. At the top of many bankers minds are the

woes of MF Global, a mid-sized investment bank that went bust at the end of October after loading up on Italian and other peripheral European government bonds. So toxic is their taint that shares in Jefferies, another mid-sized American investment bank, were pummelled over the firms trades in European bonds, despite the fact that it had shorted them and stood to benefit if they fell in price. It too has been forced to cut back both its holdings and bets that they might fall.

Now that a run on bond markets has started, it may well keep feeding on itself. After clearing houses raised margin requirements on Portuguese and Irish bonds, their prices fell sharply (pushing yields up), prompting clearing houses to increase margins yet again (see chart 1). Euro-zone bail-outs followed shortly afterwards. Rising bond yields can themselves stoke worries about a countrys ability to service its debt. Italys national debt is high, but affordable at the yields it was paying earlier this year. If its borrowing costs were to climb for a sustained period its debt would begin to look unaffordable, prompting further selling and further increases in bond yields. Borrowing costs paid by Italian banks and companies are also likely to rise. Banks are generally unable to issue long-term bonds at interest rates lower than those paid by their governments, because they would be hardest-hit by a default. Higher borrowing costs for banks will force them to rely more on the ECB to keep credit flowing; and it will mean scarcer and costlier loans for Italian companies, which in turn may slow economic growth and hamper debt repayment. Italys strongest companies can sell bonds directly, but the rates they pay are also correlated to the yields on government bonds. The very visible signs of runs in government and corporate bond markets seem to be mirrored in more opaque corners of finance. Greek banks have been bleeding deposits for months, yet panic may be setting in. Reuters reports that over the past week as much as 5 billion was withdrawn by savers. My father sent me money as a gift, to get it out, says one London-based but Greek-born banker. In Italy corporate deposits have also been moving out of the country to other members of the euro zone, or to the subsidiaries of foreign-owned banks in Italy, according to bankers.

Another sign of strain may be found in demand for 500 bills. These are too large for everyday transactions and are mainly used for mattress-stuffing or money laundering, say bankers. Demand for them surged after the collapse of Lehman Brothers in 2008, and it has ticked up again in recent months (see chart 2). Worrying, too, are signs that companies across Europe are preparing for the possibility of a break-up of the euro zone. One London lawyer says he has been inundated by requests from clients asking about the validity of contracts. There is a contractual obligation to make payment in euros, he says. People are asking what happens if there isnt a euro.