Sovereign credit woes spread to Europe's banks

* Banks suffer sovereign fallout

* Volatility puts lid on bond issuance

* Upward pressure on bank funding costs

By Jane Merriman

LONDON, Feb 5 (Reuters) - European banks are taking plenty of pain from the credit market's obsession with sovereign risk, and their credit risk compared with a benchmark index was wider on Friday than after Lehman collapsed in September 2008.

Banks have been hit by concern about their exposure to government debt and mortgage assets in countries with higher risk, particularly those in Portugal, Spain and Greece.

The market's perception of close links between banks and sovereigns threatens to raise funding costs for the financial sector which faces a mammoth refinancing in the next three years to replace maturing debts.

For example, the relationship between pricing of government bonds and covered bonds, highly-rated securities widely used in European bank funding, has become more closely aligned.

Banks in the countries bearing the brunt of sovereign worries could suffer more than others.

"A line is being drawn across Europe," said one financial institutions banker, referring to those banks that can easily raise money via the corporate bond market and those who will find it more difficult.

The Markit iTraxx Senior Financials credit default swap (CDS) index is about 13 to 14 basis points wider than the iTraxx Europe index ITEEU5Y=GF, according to BNP Paribas credit analysts.

This spread was about 8 to 10 basis points just after U.S. investment bank Lehman filed for bankruptcy in September 2008, the research showed.

"Sovereign fears are feeding into the banks," said Mehernosh Engineer, credit analyst at BNP Paribas.

Credit default swaps are derivatives used to insure against a default on a company's bonds.

Credit default swaps on Greek, Portuguese and Spanish government debt hit record highs this week as financial markets turned the spotlight on these countries' heavy debts. [ID:nSGE61407V]

Credit default swaps on banks from these countries have widened dramatically in the past month.

Five-year CDS on Portuguese bank Banco Espirito Santo (BES.LS) have jumped to 259 basis points from about 96 bp on Jan. 11, according to Markit data. Spreads had started to widen after that date, when Greece's debt issues intensified.

Five-year CDS on Banco Santanter (SAN.MC) widened to about 137 bp on Friday, from around 65.7 bp on Jan. 11, according to Markit.

Volatility in credit market spreads this week has put a damper on new bond issues in the European primary markets, where Societe Generale's (SOGN.PA) 1 billion euro 12-year covered bond on Wednesday was one of only a few bank deals. [ID:nLDE6122EI]

"It's ground to a halt," said one debt capital markets banker, who said in current volatile market conditions only the "best names" would like be able to raise money. (Editing by David Holmes)