The worst performer in today’s European equity route is Aviva (the old Commercial Union), down by nearly 30%, followed by Prudential PLC, Friends Po, Legal and General, and ING, all down around 20%. The insurance sector, down 8% overall, is the worst in the broad DJ Stoxx index.

Credit protection for the insurers is looking ugly as well. Aegon 5-year protection is out around 100 basis points for both senior and subordinated debt this morning, and out about 200 basis points in the past week. Similar spread widening has affected the rest of the sector.

Citigroup’s dilution last week probably contributed to the mess. By forcing conversion of the preferred shares to common, the US Treasury took the first baby step of haircutting debtors. Granted that non-cumulative perpetual preferred shares are not debt in a legal sense (although they carry a coupon and a credit rating), and that Citigroup will continue to pay the trust preferreds one notch higher on the capital structure, the market still perceives bank debt as far less safe than it was a week ago. Bank of America’s subordinated debt now costs LIBOR +520 basis points to insure, an increase of about 100 bps over the past week.

As I keep emphasizing, the pyramid scheme that links insurers and banks (insurers own the capital securities of banks and provide first- or second-loss protection for bank positions in a variety of ways) makes it impossible tokeep the two sectors separate.

Insurers used to be yield hogs. AIG was the worst, writing protection with abandon on asset-backed Collateralized Debt Obligations, effectively shorting a mass of put options - which is how it racked up the worst corporate loss in American history last quarter. But the rest of the insurers did the same thing, albeit with a bit less greed, scarfing up barely-investment-grade tranches of asset-backed deals that amount to second-loss pieces, and similar parts of the capital structure in commercial mortgage backed securities.

If the capital securities of the banks are at risk, starting with preferred stock, and then going to trust preferreds, subordinated debt, and so forth, then the insurers are in deep trouble. The haircut at Citigroup may have been mild — unlike Fannie and Freddie under conservatorship, the preferred’s were not killed, but merely put up for a forced exchange — but a haircut is a haircut. And if the insurers get into serious trouble, the financial system takes another ratchet down.

As the FT’s Lex column wrote March 2,

The Treasury, then, distinguished between two types of hybrid securities, lumping preferreds into equity and treating trust preferreds as closer to debt. Common shareholders merely have an option to benefit should Citi fight back to profitability. CreditSights thinks the distinction signals support for all debtholders. But previously senior trust preferreds now rank pari passu with new government securities (the preferred shares not converted) which could set nerves jangling should Citi’s state deteriorate again. That risk prompted Standard & Poor’s to downgrade all Citi’s hybrids on Friday. The government, having reset the rules, needs to make plain its intent to play by them.

The ambiguity of the Treasury’s position weighs heavily on the insurers, who are in the crossfire right now.

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