Innocents Abroad

Why European banks were the big losers in the U.S. subprime meltdown.

U.S. financial institutions have been hard hit by the subprime-mortgage mess. This summer, two Bear Stearns hedge funds that invested in subprime mortgage bonds went belly-up. Citigroup on Monday blamed problems with subprime bonds for charges it must take against earnings. Generally speaking, however, the financial complex has collectively weathered the credit storm rather well. Goldman Sachs last month reported a blowout quarter.

European banks haven’t been quite so lucky, as some of the biggest names in continental finance have been laid low on U.S. subprime debt. In March, Natixis, a large French bank, said it had $1.4 billion in exposure to the U.S. subprime market, having extended credit to failed subprime lender New Century Financial. In July, IKB, a German business lender, came a cropper on bad subprime bets, precipitating a bailout. In August, state-owned SachsenLB, having made similarly ill-timed investments in U.S. subprime mortgages, bailed out and then sold at a knockdown price. On Monday, Swiss giant UBS, a far larger and more sophisticated operation, said that problems, “mainly related to deteriorating conditions in the US sub prime residential mortgage market,” would force it to take a charge of about $3.4 billion and cause the company to suffer its first quarterly loss in nine years. Executives’ heads rolled.

It’s common for globalists to mock the haplessness of American tourists and businesspeople abroad—their aggressive lack of understanding of foreign cultures, their inability and unwillingness to learn foreign languages—and to laud the facility with which Europeans conduct business across borders. After all, European companies that wish to gain scale, almost by definition, must be comfortable operating in a range of markets. (Swiss banks became multinationals in part because their home market was so small.) And many European banks have been quite successful expanding in emerging markets like Asia. German giant Deutsche Bank operates in 75 countries.

And yet European banks somehow tend to do poorly in a developed market that should be intelligible to them: the United States.

We’ve seen this pattern before. Much of the capital raised by New York-based banks to fund the railroad boom of the late 19th century came from British, French, German, and Dutch investors. And they bore the brunt of the losses when a recession in 1893-94 caused many railroads to go bust. Then, as now, the exuberance of the New World turned out to be a honey trap.

Although technology and telecommunications render distances less relevant than before, market presence still matters. Sure, UBS and the European banks have their own teams of economists and analysts, and some have built significant U.S. operations.

But the traders and analysts with the best and most intimate knowledge of the U.S. market still flock to American institutions. Goldman Sachs, Morgan Stanley, and the vast number of New York-area hedge funds are far more likely to hire, promote, and retain hotshot New York-based traders than a French bank like Natixis.

Think about how stupid a tourist can feel in a souk in Marrakech. Unfamiliar with the language and unsure whom to trust, tourists lack the tools and instincts to figure out the price and value of exotic goods. Just so, foreign banks made easy marks for the exotic merchandise produced in Manhattan’s souk during the credit bubble—securities based on subprime loans, collateralized debt obligations, and all sorts of structured debt products. These innovations appealed to European banks because they offered the beguiling combination of security and higher yields. In this era of low global interest rates, investors seeking high-yielding debt have to assume much greater risk, like buying bonds issued by Ecuador’s government. But subprime bonds offered higher payments than Treasury bonds or garden-variety mortgage-backed securities. And because they were issued in the United States, a wealthy market with a strong economy, they seemed safe. What’s more, the alchemy of credit ratings allowed Wall Street to turn some subprime bonds into AAA-rated debt instruments. For European banks, based as they are in a low-growth, inflation-phobic economy, subprime bonds were very appealing.

Experienced tourists also know that to avoid trouble, you have to travel to exotic foreign markets in season. The same holds with investing, especially in a cyclical business like credit. During bubbles, foreigners and outsiders tend to be the last to enter the market—and thus the first to get hurt when the bubble pops. Subprime bonds issued in 2002 and 2003 have performed quite well, all things considered. But those investors that started committing large sums of capital to the subprime market in 2005 and 2006 were like tourists who paid high-season prices to travel to the Caribbean in October: They checked in at very high rates just in time for a devastating storm.