Are euro zone bonds the new subprime?

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So we all by now know the story of how the global economy fell into the 2008 financial crisis. Banks gorged themselves on high-yielding U.S. subprime mortgage securities, which were awarded top credit ratings (perhaps fraudulently). When those investments proved as financially sound as the over-leveraged homeowners behind them, the foundation of the financial system crumbled like cheap Chinese wallboard. From Wall Street, the shockwaves ricocheted around the world. And we ended up in the Great Recession.

Now we have to ask if something similar is going on in Europe. But this time around, a very different sort of subprime security is at the heart of the problem – the sovereign bonds of euro zone countries. Here’s what I mean:

Just as deteriorating subprime securities ate away at the balance sheets of major American and European banks, the same could happen with euro zone bonds issued by the weak PIIGS. Those bonds are already losing value as yields escalate. Even if Greece manages to avoid a default, the second bailout package has losses built in for private holders of Greek bonds. In a scary scenario, the euro crisis deepens, the bonds of Greece, Ireland, Italy and the other PIIGS lose more and more value, weakening the European banking sector. Banks in Europe holds billions of dollars of PIIGS bonds, so the impact could be severe. Then the fallout gets spread around the world through globalized banking and financial markets. And it’s 2008 all over again. Here’s how economist Ken Courtis put it in a recent, anxiety-ridden email:

Several banks are going to look like BSC or LEH.. and not just PIIGS banks… think BNP, think Barclays,… Some of these banks have exposure to PIIGS sovereign debt several times their equity. Then there are other PIIGS exposures, such as investments in PIIGS banks, loans to PIIGS companies, local real estate market exposure….which only increases further the vulnerabilities…On its present course, Europe is on a crab walk to disaster…and should that happen, there would be very few places to hide, for anyone.

Holy junk bonds, Batman! How likely is such a scenario? It is always extremely difficult predicting financial crises, and I don’t intend to try it out myself. However, the euro zone sovereign debt crisis does appear to be morphing into a renewed banking crisis. The shares of major European banks have taken a vicious pounding in recent days amid fears that Greece will default. On Wednesday, Moody’s downgraded the credit ratings of two of France’s most important banks — Societe Generale mainly because of the impact the debt crisis could have on its financing, and Credit Agricole in part due to its exposure to Greece. Christian Noyer, governor of France’s central bank, brushed off the downgrades as “very small,” which they are. But Noyer is missing the point. Concern about the health of Europe’s banks has always lurked in the background of the debt crisis, but European leaders have generally ignored it (with exceptions, such as a bank restructuring effort in Spain). Europe-wide “stress tests” of the region’s banks, aimed at bolstering confidence in the sector, were generally criticized as too soft. So like two enfeebled octogenarians trying to hold each other upright, a potentially shaky banking sector has been supporting debt-laden, wobbly governments, which then are expected to back up the banks.

However, at the same time, we shouldn’t get too far ahead of ourselves. In its announcement of its downgrades, Moody’s made clear the France’s banks had the capital to absorb losses on Greece, as well as Portugal and Ireland. That means the euro debt crisis is likely going to have to get significantly worse to really undercut banks in Europe. My guess is that jitters about the banks in Europe will ease if the uncertainty over the continued bailout of Greece is resolved. In other words, euro zone bonds aren’t quite subprime – at least not yet.

But the risk is out there. If Europe’s leaders really want to stem the debt crisis, they should find ways of shoring up the banks, or getting the banks to raise their own capital, before we do face a renewed subprime crisis. My fear is that the lack of foresight among Europe’s politicians that has gotten the euro zone into this mess will persist, placing the European financial system in danger. And then, as Courtis says, there would be nowhere to hide.

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