Ties That Bound Europe Now Fraying

By STEPHEN FIDLER And DAVID ENRICH

The Wall Street Journal

… debt worries spread until they set in train a reversal of the historic process of European financial integration…

… the financial lifeline of some European states is ebbing away…

… The euro's first decade was much different…bond yields exceeded their interest cost for repo loans…

…The assumption that euro-zone government bonds were almost interchangeable and none could default steadily began to crumble …

…A turning point for euro-zone investment came in July. …investors in its bonds would take losses.

… The EBA … announced it was recalculating banks' capital needs.

… Investors haven't been convinced by European leaders' efforts…

BRUSSELS—A common currency drove investors to Europe's outer reaches, then scared them away.

The first decade of the euro intertwined the Continent's financial systems as never before. Banks and investment funds in one euro-using country gorged on the bonds of others, freed of worry about devaluation-prone currencies like the drachma, lira, peseta and escudo.

But as the devaluation danger waned, another risk grew, almost unseen by investors: the chance that governments, no longer backed by national central banks, could default.

The first hints of such a peril came with Greek budget problems, and as investors grew increasingly wary of Greece, debt worries spread until they set in train a reversal of the historic process of European financial integration—with manifold consequences now being played out.

Banks, insurance companies and pension funds in Northern Europe have slashed their lending to overextended countries to safeguard their money. Many now are comfortable investing only at home or in the safest markets such as Germany.

"We are seeing this deglobalization, a 'de-Euroization,' of the euro zone," said Andrew Balls of Pimco, head of the big bond shop's European portfolio management. "Investors are going back to their own markets. They may still hold bonds, but they won't have them spread across the euro zone as they had before."

If fiscal recklessness in some quarters sowed the seeds of the euro crisis, it was investment decisions inside the euro zone that worsened it and made it intractable.

Having beaten a retreat, the big investors in Northern Europe aren't likely to return to bond markets in the periphery any time soon, participants say. Carsten Brzeski, an economist at ING Bank in Amsterdam, believes that a "home bias" will persist even if political leaders can find a solution to the immediate crisis. "Investors do not forget easily," he said.

Said Philippe Delienne, president and chief executive officer of Convictions Asset Management in Paris, which manages €776 million in assets: "Everyone has stopped investing in certain parts of the euro zone."

He added, referring to Germany's bonds: "You can't say any longer that Italy is like the bund…To protect ourselves now, we are buying bunds."

For the heavily indebted nations that must repeatedly replace maturing debt, the investment ebb tide portends a long struggle.

The scale of the shift suggests that the euro zone isn't merely suffering from a short-term confidence crisis but that the financial lifeline of some European states is ebbing away, perhaps not to return for years, leaving some countries exposed and in danger of financial breakdown.

At worst, the squeeze could spell a wave of sovereign bankruptcies that threatens to cripple Europe's banking system, provoking a deep recession in the process. One result could be a departure by one or more countries from the monetary union, or even its breakup.

Investors' retreat showed no sign of letting up this week after a summit of European Union leaders last Friday failed to deliver measures that appeared able to resolve the crisis.

The euro's first decade was much different. The currency was introduced in 1999. Investors—their devaluation worries banished—viewed the bonds of Mediterranean economies as a close substitute for those of Germany and other solid economies, and were drawn to them by slightly higher yields.

Another lure was that pension-fund clients preferred investments in the currency their liabilities were denominated in, the euro.

Regulatory incentives gave a push, too. The European Central Bank lets any bank in the euro area deposit government bonds in return for short-term loans, under so-called repurchase, or "repo," agreements. This was profitable for banks, since bond yields exceeded their interest cost for repo loans, and was initially a spur to buy euro-zone bonds.

The ECB monetary operations helped make it easy for weaker nations to borrow at rock-bottom rates. And the operations fostered the view that a euro-zone sovereign borrower would never be allowed to fail, say Simon Johnson, a former IMF chief economist, and Peter Boone in a paper they wrote for the Peterson Institute for International Economics.

Because the default risk was seen as zero, European banks didn't have to hold capital in reserve against euro-zone government bonds they owned. That gave banks a further motive to buy them, especially after the 2008 financial crisis ate into banks' capital buffers.

A rare dissenter from the clamor to own these bonds was Heineken NV's pension fund. It dumped tens of millions of euros' worth of bonds from less-solid governments as early as 2005. "The yield pick-up…was so low compared with the risk involved, we decided to sell everything around the Mediterranean and invest only in Dutch and German government bonds," said Frank de Waardt, managing director of the €2.2 billion fund. "We sold Greece, Italy, France and Portugal. We even sold Finland," he said.

The fund's performance suffered versus its peers, as many others glommed onto the debt of nations on the periphery.

In Greece, where the preponderance of its bonds were once Greek-owned, foreign holdings of them reached 55% by 2003. By the third quarter of 2009, it was 76%.

That was just weeks before a new government in Athens disclosed the country's budget deficit was far worse than believed. The assumption that euro-zone government bonds were almost interchangeable and none could default steadily began to crumble.

First, Greece was forced to go hat in hand to the International Monetary Fund and other euro-zone nations. Then, Germany made plain it didn't intend to foot the bill indefinitely for the debts of what it saw as profligate governments.

German concerns were crystallized into euro-zone policy.

In October 2010, on the boardwalk of the French resort of Deauville, German Chancellor Angela Merkel and French President Nicolas Sarkozy agreed that any bailouts after 2013 would require involvement of the private sector, which would have to take reduction in the value of its government-bond holdings.

That possibility sent investors scurrying away from a wider group of governments, leading to a surge in their interest costs that was slowed, in some cases, by ECB bond buying.

The share of Greek bonds in the hands of investors outside Greece has since fallen steeply to well below 50%.

Figures from Fitch Ratings show how foreigners have retreated from weaker euro-zone sovereign-bond markets across the board, leaving the bonds in the hands of domestic investors.

It isn't only in sovereign debt that Europe's financial integration has gone into reverse. Euro-zone banks' holdings of assets of all types, including corporate loans, in Cyprus, Greece, Ireland, Italy, Portugal and Spain hit $1.9 trillion in 2007, up sixfold from 2001, but then declined 44% as of June 30, according to Barclays Capital. Barclays based its calculations on data from the Bank for International Settlements, or BIS.

Portugal's Banco BPI SA had been an enthusiastic buyer of government bonds from elsewhere in the euro zone. By September, it had sliced its portfolio about 30%, according to regulatory disclosures.

Now, "we will invest most likely in German bonds or something similar," said Fernando Ulrich, chairman of the executive committee.

Volatility is a factor in the disenchantment. That itself increases risk, according to institutions' pricing models.

Downgrades by rating firms have also deterred investors, some of which have limits on how much low-rated paper they can hold.

Italy's bonds long remained fairly stable. For instance, French banks were buying more of them earlier this year, and owned 9% more at midyear than at year-end 2010, BIS data show.

The stability didn't last. Italy's market turned volatile in July and August following disagreements between then-Prime Minister Silvio Berlusconi and his finance minister Giulio Tremonti over a series of issues.

A turning point for euro-zone investment came in July. European leaders, in negotiating an expanded Greek bailout, confirmed that investors in its bonds would take losses.

"It was a wake-up call for the industry," said a top French bank executive, who soon started dumping his Italian government bonds. Deutsche Bank AG said it substantially reduced its "net exposure" to Italy, both by selling bonds and buying default protection.

Policy makers' moves this fall may have exacerbated cross-border disinvestment.

The European Banking Authority, or EBA, had subjected banks in July to "stress tests" to see how well they could weather trouble.

But by early October, the regulators were eager to send a signal they had a handle on the crisis and to force weaker banks to bolster their capital. One option was to re-crunch the stress-test numbers, in a way that reflected the possibility—not considered before—of losses on euro-zone government debt.

For such an exercise, banks would have to value these bonds not at their expected long-term values but at the current depressed market values.

The banks lobbied against such a step, fearing it would expose big holes in their balance sheets. A top executive at France's BNP Paribas SA warned regulators that "the moment you change the rules, we have to sell" bonds from peripheral Europe, said a person familiar with the matter.

When the board of the EBA met in the first week of October, the routinely scheduled gathering, held in the EBA's offices with panoramic views of central London, took on an emergency tenor.

EBA officials acknowledged a strong risk that banks would dump government bonds in response to toughened stress tests, said people familiar with their thinking. But they felt in a bind, because critics had derided the initial July stress tests as too weak. Tougher ones might help restore shaken confidence in banks.

The board members also were under the impression that EU leaders in Brussels were poised to unveil a comprehensive plan to stabilize the Continent's financial system, said those familiar with their thinking.

As a result, the regulators hoped, sovereign-bond prices would come back somewhat and banks wouldn't face pressure to sell.

The EBA plowed ahead. On Oct. 26, it announced it was recalculating banks' capital needs.

Bank reactions were swift. The Association of German Banks wrote to EBA Chairman Andrea Enria of Italy, saying regulators' policy risked "a fundamental change in the perception of sovereign exposures."

Across Europe, banks started selling bonds issued by Italy, Spain and other heavily indebted euro-zone governments, regulatory filings show. The stampede was partly an attempt to reduce the amount of capital banks needed to reserve against possible losses on such bonds, as well as an effort to avoid the wrath of risk-averse investors, executives say.

BNP Paribas rid itself of more than €8 billion of Italian debt from June through October. Belgian lender KBC Groupe SA cut its portfolio of Southern European bonds by about half.

Even some Italian banks, which long had been dutiful buyers in Italian treasury auctions, moved to the sidelines. Regulatory filings show banks in Italy, Germany and Spain cut their holdings of French, Belgian and Luxembourg government bonds by half or more.

Heading back to its home market, Spain's No. 2 bank, Banco Bilbao Vizcaya Argentaria SA, virtually eliminated its €504 million portfolio of Finnish government debt.

In some cases, such as KBC's, executives said they racked up tens of millions of euros of losses by selling in a hurry at cut-rate prices.

Despite the fire sales, the regulators found that Europe's biggest banks still faced a substantial capital shortfall.

The July stress tests had showed them in need of just €2.5 billion in additional capital; results of the new exam, revealed this month, raised this to about €115 billion.

What would it take to get Europe's big investors buying the peripheral euro-zone countries' debt again? Investors haven't been convinced by European leaders' efforts at last week's summit to play down the likelihood that bondholders would face losses on future country bailouts.

The Transport Industry Pension Fund of the Netherlands sold Greek bonds last year, followed by Spanish bonds and then short-maturity bonds of Italy, according to its chief investment officer, Patrick Groenendijk. It still owns some longer-term Italian bonds.

Asked when it might invest new money in the Italian market, Mr. Groenendijk was blunt. "If you want an honest answer, when they have their own currency," he said.

—Brian Blackstone,

Tom Lauricella, William Horobin and Laura Stevens