We’ll spare you the suspense.
The answer, according to Goldman Sachs analysts Ben Broadbent and Nick Kojucharov, is no, it probably isn’t. Or, at least it won’t be as long as defaults stay below a certain threshold.
Here’s the thrust of their (brief) analysis:
That the authorities say they will take such action is no surprise, and we believe they’ll be successful in safeguarding stability— should the need arise. Nevertheless, as was the case after past financial crises, government debt is rising sharply as the private sector de-levers, and history shows that incidences of sovereign default increase after financial crises. As a result, sovereign spreads have widened and, with a share of that debt held by banks, some have wondered if this could be ‘the European subprime’.
Needless to say, the ramifications of an outright default anywhere in Europe would be considerable. But, in scale at least, the problem looks considerably smaller than subprime. European banks’ exposure to sovereign debt is half that of US banks to mortgages in mid-2007. We find that, under some reasonable assumptions, it would take the default of nearly half of non-German Euro-zone government debt in order to replicate the hit to banks’ balance sheets that was inflicted by the US mortgage crisis. To us, that seems a very tall order.
So the first point is really that European banks are less exposed to government bonds than US banks were to mortgages in the year before the subprime crisis.
The government bond market itself is smaller in Europe, according to Goldman. It’s equivalent to roughly 65 per cent of GDP versus the nearly 80 per cent of the mortgage market and US GDP.
Plus, the European banking sector’s share of the government debt market is also smaller, at 25 per cent, than the US banks’ share of mortgages, as the below chart should show:
There’s a bit of a caveat here:
This is not to say that other owners [of sovereign debt] wouldn’t react adversely to asset write-downs. In response to an explicit sovereign default that triggers a formal accounting loss and a hit to capital, European insurers—who own around €1trn of government bonds (our estimate)—might have to raise more capital and reduce holdings of other, risky assets. This would depress equity prices and tighten financial conditions. There might also be wealth effects on spending by households, who probably own over €1trn-worth of sovereign debt.
But the US mortgage crisis has taught us that it is the leveraged institutions that play the most important role in transmitting and amplifying the original shock through the rest of the economy (see ‘More Thoughts on Leveraged Losses’, US Economics Analyst 08/10, March 7 2008). The distribution of the at-risk asset, and in particular the proportion held by banks, therefore matters.
Back to the question at hand then — possible European bank losses on sovereign debt.
The US mortgage crisis inflicted first-round losses equivalent to about 4 per cent of GDP, according to Goldman, half of which fell on the banks. By Goldman’s estimates the hit for Europe’s banks shouldn’t be as high — in fact it should be something like losses equivalent to 0.3 – 0.7 per cent of GDP.
Here then is Goldman’s heavily-conditioned conclusion:
Even for economists happy to accept approximation, this is an uncomfortably imprecise exercise. We are also reluctant to offer ranges of our own. While we think noncommercial funding for the most at-risk sovereign (Greece) will probably be required, our central expectation is that such funding will eventually be forthcoming and that the chances of outright default are very low, particularly across the Euro-zone as a whole. But the uncertainties involved are considerable.
It’s also true that we have restricted ourselves to only a very limited comparison and that, even without outright default, changes in the perceived risk of it can still tighten financial conditions. Notably, there has been a clear cross-country correlation in the past three months between changes in sovereign CDS and the performance of banks’ equity prices (Chart 6). As sovereign debt cheapens, funding costs go up for everybody, inflicting immediate damage on the most leveraged institutions . . .
As a summary comparison it’s helpful to think of what’s required to match the two. We’ve estimated that the initial hit from US mortgage losses was worth 4% of GDP, of which a half fell on leveraged-sector balance sheets. To get the same aggregate impact from Euro-zone sovereign losses, assuming losses-given-default of 35% (the baseline assumption in the CDS market) and remembering that debt is around two-thirds annual GDP, you’d have to expect a default rate of 18% (over whatever horizon you think is relevant).
If we assume that German sovereign debt is essentially risk-free, that means a 24% expected default rate in the rest of the Euro-zone. If you believe that what matters is the losses borne by the banks—and there’s no doubt that the leveraged sector played a key role in the amplification and propagation of the original hit in the US mortgage market—that threshold rises to close to 50%.
Could this be the European subprime? Yes, but only if Europe suffers a wave of sovereign defaults unprecedented in scale and at significantly lower levels of debt (relative to revenue) than those of the past.
So this shouldn’t be Europe’s subprime as long as defaults and correlations stay within an expected range.
Where have we heard that before?
Related links:
Bank Grεεkery – FT Alphaville
US banks have $176bn in exposure to troubled Europe, BarCap says – FT Alphaville
Banks, insurers and sovereign debt - FT Alphaville
Next up for Europe, covered bond catastrophe? – FT Alphaville
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