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Wednesday, October 5, 2011

Markets roiled as European banking meltdown widens

DANIEL ROLAND/AFP/Getty Images

Markets tumbled around the world for most of Tuesday on concern that the debt crisis had spun out of control, but staged a dramatic late recovery on reports that European governments are working on a plan to refloat the worst-hit lenders.

What analysts have been warning about for more than a year has come to pass: troubles sparked by Greece and indebted Mediterranean countries have spilled over into other sectors, triggering another crisis potentially as bad as the one that began in 2008.

Financial services giant Dexia on Tuesday became the first victim of a widening banking meltdown in Europe as the struggling Brussels-based lender confirmed it is considering a plan to sell off operations to cope with massive losses from exposure to Greek sovereign debt.

“I think this is just the beginning,” said Brad Smith, an analyst at Stonecap Securities in Toronto. “There are plenty of other banks with exposure to Greece [and some of them are next in line].

The dramatic reversal — a 4% turnaround in some of the major North American stocks indexes in a matter of minutes — was spurred by a Financial Times report that said European leaders were urgently looking at co-ordinated action to sink money into some of the continent’s banks.

“There is a sense of urgency among ministers and we need to move on,” Olli Rehn, European Union commissioner for economic affairs, told the Financial Times.

Meanwhile, the Greek finance minister said the country, which seems almost certain to default, has enough cash to operate for another six weeks, after European ministers delayed a decision on the country’s next emergency loan instalment.

But Greece is a relatively small player in the scheme of things compared with other troubled countries. The rating agency Moody’s Investors Service delivered another shock to the market late yesterday, announcing it downgraded Italy’s government bonds by three notches, citing growing risk that indebted countries such as Italy face increased challenges convincing investors to buy their bonds.

At the core of the sovereign debt crisis is uncertainty and confusion over the ability of countries to meet their obligations and avoid default. Most of the concern at first centred on peripheral nations like Greece and Ireland but as governments disclosed further information it became apparent that the problem is far greater than was at first realized, with much larger economies already under pressure.

The troubles quickly spread to the financial system as European banks are among the biggest holders of risky sovereign bonds. European regulators had plenty of warning and even put their lenders through extensive stress tests meant to pinpoint potential problems before they started.

But from the beginning critics warned the tests were not tough enough. They’ve been vindicated as many of the lenders that are now under water passed their tests with flying colours.

Now three of Europe’s banks with the biggest exposure to Greece — Dexia, Paribas SA and Societe Generale SA — are opposing pressure from regulators to write down the value of their Greek bonds to reflect the market value, according to Bloomberg News.

While most other lenders have cut the value of their holdings in half, the three lenders have cut their Greek holdings by only 21%.

Under current accounting rules there’s nothing wrong with the practice, and that’s part of the problem. By not taking the full writedown, the lenders avoid about 3-billion euros of losses that they would otherwise have to acknowledge, which only add to a lack of clarity in the European banking system.

Unlike the last financial crisis, the potential consequences of the current debacle are unlikely to include failure of the global financial system. But it comes as the global economy is weakening, and analysts say there is a real risk that it could turn what might have been a mild recession into something much worse.

Canada, however, is in a strong position. Having made it through the last crisis with minimal losses, Canadian banks are well capitalized and unlike many of their peers on Wall Street, they are in a position to benefit from the problems at European lenders.

For example Dexia has a joint venture with Royal Bank of Canada, and it may be forced to sell its share of the business if it ends up taking a government bailout.

RBC Dexia, one of the world’s largest custody banks, has operations in more than a dozen countries.

National Post

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