Italy intervenes in bond market as spreads soar

By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, March 6, 2008

http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=&xml=/mone...

The Italian treasury has taken the highly unusual step of intervening in the debt markets to prevent a further surge in government bond yields as hedge funds with heavy exposure to the region scramble to raise liquidity.

A flight to safety has pushed the yield spread between 10-year Italian bonds and equivalent German Bunds to 55 basis points, the highest since the launch of the euro. A similar pattern has emerged across the southern belt of the eurozone, with spreads hitting post-EMU highs of 53 versus Greece, 44 for Portugal, 38 for Belgium, and 36 for Spain.

A report in Italy's financial paper Il Sole said the sudden surge in spreads recalled the dramatic events of 1998 when the US hedge fund Long Term Capital Management was forced to liquidate huge positions in Italy and Spain, setting off a systemic chain reaction.

The newspaper reported that the Italian finance ministry had stepped in late on Tuesday to support the market by mopping up 10-year BTP treasuries. Investors had been encouraged to swap the "old bonds" for new five-year instruments, alleviating the stress in the most neuralgic part of the financial system.

An Italian treasury official told the Telegraph that the move was intended to help funds weather the current bout of severe turbulence. "We're helping them swap illiquid securities for more liquid," he said. "It is unusual for us to do this at this time of year."

The European Central Bank said the action did not violate the rules of monetary union. The Italian central bank is prohibited from buying Italian government debt under EU treaty law as this would inflate the common currency, but the treasury can adjust debt maturities if it wishes. The latest action is nevertheless highly sensitive. ECB lawyers are likely to keep a close eye on all moves by Rome to support the bond market.

In France, Credit Agricole reported a E3.3-billion write-down on US subprime debt and losses stemming from bond insurers. Fourth-quarter losses reached E857 million. Chief executive Clemence Bounaix, said there would be no further losses. "It's disappointing but the risks and exposures are now known and the market feels it can turn the page," he said.

Mark Ostwald, a bond expert at Insinger de Beaufort, said there had been a mass dumping of risky assets worldwide as banks and funds sought to cut exposure to the swap markets. "Club Med bonds have been hit hard. People have realized that countries like Italy and Spain have not carried out the reforms needed to control wages and boost productivity, and are now getting into trouble," he said.

"This has not yet become a serious issue because bond yields are low. It becomes a nightmare is if the yields start backing up again," he said.

One expert said a major investment bank had been heavily involved in the Italian market promoting an "arbitrage play" in which long positions on Italian bonds were offset by credit default swap insurance. This may have created an unstable mismatch since the two markets are moving to a different rhythm, perhaps triggering liquidation sales.

Service sector confidence in February was extremely weak in both Spain and Italy, highlighting the growing economic rift between the north and south of the eurozone.

"These countries cannot devalue their way out of trouble as they used to do," said Simon Derrick, a currency strategist at the Bank of New York Mellon.

"The stress is surfacing in the bond markets instead as the default risk rises. Italy is now in the worst off all possible worlds because it needs lower rates to cushion the downturn. Instead it will have to pay higher rates on its debt. We are reaching the point where it could become a significant political issue," he said.

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