Debts & Loans

It is not surprising that European Union finance ministers looked ashen faced in Brussels on Tuesday.

The breakfast meeting discussed how EU governments should deal with, in other words pay for, the "toxic" banking assets that triggered the economic crisis.

As discussed here on Monday, the European Commission warned that government attempts to buy up or underwrite "impaired" assets could plunge the EU into a deeper crisis, one that threatens the Union.

Everyone is terrified that a second bank bailout will push up government borrowing at a time when bond markets have growing doubts over the ability of countries such as Spain, Greece, Portugal, Ireland, Italy and Britain, to pay it back.

"Estimates of total expected asset write-downs suggest that the budgetary costs - actual and contingent - of asset relief could be very large both in absolute terms and relative to GDP in member states," a confidential EC document, seen by The Daily Telegraph, cautioned.

 "It is essential that government support through asset relief should not be on a scale that raises concern about over-indebtedness or financing problems."

Spread yields are widening on bond markets as investors judge it riskier to buy the debt of a country like Italy than the debt of another like Germany.

In line with the risk, and the low performance of some EU economies compared to others, the markets have demand a higher premium on government bonds issued to raise the cash.

The more the doubt there is over high levels of government borrowing, the more the markets have asked governments to pay to service their borrowing and all the more indebted countries become.

Ministers and officials fear that the process could lead to vicious spiral that threatens to tear both the euro and the EU apart.

"Such considerations are particularly important in the current context of widening budget deficits, rising public debt levels and challenges in sovereign bond issuance," the EC paper warned.

"The limitations on the budgetary capacity of some member states in providing asset relief are already evident in a significant widening in the spreads on government bond yields relative to benchmarks."

"It is clear that investors have become more discriminating among sovereign issuers on the basis of credit risk."

As the cost of borrowing, it may be that some smaller countries, Ireland perhaps, can not afford to bailout their banks as part of an EU-wide strategy.

"For some member states, it maybe the case that asset relief for banks is no longer an option, due to their existing budgetary constraints and/or the size of their banks' balance sheet relative to GDP (i.e.the big bank-small country problem)," the paper warned.

"The extent of any risks to the EU banking system as a whole from an inadequate response in these Member State needs to be considered, particularly in the case of cross-border banks."

There is trouble ahead. Is it possible to buck a crash?

Figures evaluating the 41.2 trillion euro of assets held on EU bank balance sheets are eye watering.

"Banks have already taken steps to address the problem of impaired assets, i.e. they have recorded substantial write-downs in asset values, taken steps to limit remaining losses by reclassification of assets within their balance sheets and gradually put additional capital aside to strengthen their solvency positions. However, it seems that the problem has not been resolved to a sufficient degree. As market illiquidity has driven prices further down and the unexpected depth of the economic slowdown now threatens a broader deterioration in credit quality and a further wave of defaults uncertainty about the asset quality of banks - despite early government support measures- remains. By removing the high uncertainty related to asset valuations through direct relief measures, it is expected that confidence in the banking sector can be restored and normal bank lending to the real economy will resume."

"From mid-2007 to date, there has been a total of USD 1063 billion in asset write-downs, of which USD 737.6 billion has been reported by US-based banks and USD 293.7 has been reported by European-based banks. Of the latter, USD 68 billion has been reported by banks and insurances in Switzerland. Despite the scale of asset write-downs already reported, the IMF currently estimates that the total bank losses related to asset impairment is likely to reach USD 2,200 billion. This figure is based on global holdings of US-originated and securitized mortgage, consumer, and corporate debt. This estimate has been steadily rising since the beginning of the crisis and some market commentators suggest that total losses may be substantially higher. For example, Nouriel Roubini who has consistently argued that official estimates are too low now suggests that total losses could be USD 3,600 billion for the United States alone."