Monday, 1 March 2010

Sovereign Debt....Sub-Prime Mark II...

In my Money Week column this week, I've ben arguing that the sovereign debt crisis is very similar to the sub-prime crisis. Here's a taster....

How bad is the sovereign debt crisis going to get?
On the surface, the rising tide of government borrowing needn’t necessarily be catastrophic. After all, even with epic, Gordon Brown-style mismanagement, it’s pretty hard for governments to go bust: they can always just raise taxes to pay off their debts. And there is a queue of Keynesian economists to tell us cheerfully that all the money spent on ‘stimulus packages’ will make the economy grow faster, and so pay for itself in higher tax revenues.
But three factors have the potential to turn this from a serious but containable problem into a full scale crisis: contagion from one country to another; the greed of the financial system; and, perhaps most seriously the dishonesty of both the governments and banks involved in covering up who owes how much to whom.
Indeed, the closer you look at it, the more it looks like a replay of the sub-prime crisis that froze the financial system two years ago.
Start with contagion.
The sub-prime crisis started with some problems in the housing market. By itself, that shouldn’t have been a huge problem. It didn’t end there, however. It quickly spilled over into the bond markets, the derivatives markets, and finally the banking system, until it had become a full-scale financial crash.
The same is happening with sovereign debt. It might have started in Greece, but attention quickly turned to the other so-called PIGs: Portugal, Italy, and Ireland and Spain. Now it is shifting to Britain. Yields on UK government debt are already higher than Spain or Italy, an unprecedented humiliation (Italy, after all, always used to be a by-word for fiscal irresponsibility). Soon it will turn on Japan and the US. The problem just spreads and spreads.
Next, greed.
The financial markets have got used to an endless succession of free lunches. Banks invested in bonds issued by Greece, Portugal, and Spain, even as those countries racked up huge debts, because they assumed they were just as safe as paper backed by the German or French government. They thought they could pocket the extra yield, without having to shoulder any significant risk that they wouldn’t get their money back.
Now that it turns out that the higher yielding assets were - surprise, surprise - a bit riskier as well, the markets are clamouring for a bail-out. But the European Union treaties explicitly prevent the debts of one euro member being re-paid by another.
Just as in the sub-prime crisis, the greed of many investors for higher yielding assets led them to take too many risks. They got burnt on sub-prime mortgages, and now they are getting burnt on sub-prime sovereign debt as well.
But the most worrying comparison between the two crisis’s is dishonesty.
One of the main reasons the sub-prime debacle turned from a relatively containable problem in the American housing market to a global financial meltdown was the widespread fiddling of the figures. Dodgy loans to people with poor credit ratings, and not much income, were rolled up into complex financial instruments, stamped triple A by the ratings agencies, then sold on to people who didn’t really understand them.
In the end, no one knew who owed what to whom. No one trusted anyone. The result? The system froze up.
Exactly the same is happening with the sovereign debt crisis.
We now know, for example, that the figures the Greeks used to get into the euro were largely fiddled. But, even worse it turns out the banks have been complicit in hiding the extent of the Greek government’s borrowing. At least 15 securities firms, including Goldman Sachs, were involved in creating complex ‘swap’ instruments that allowed the Greek government to defer interest payments until later years, and so hide yet more borrowing under the carpet. At the insistence of the Germans, the EU is now investigating.
The trouble is, that kind of creative accounting has been going on everywhere. The Italians pulled similar tricks to help massage their borrowing figures, often by swapping Italian debts into yen. Meanwhile, the ratings agencies have hardly covered themselves in glory. They have downgraded Greece, but probably not to the extent that they should. It is shocking that they haven’t downgraded the UK yet, and it is hard to believe that the only reason they haven’t is because they don’t want to offend the British government (a significant customer, let’s remember). No one really believes that the UK is a triple A rated borrower anymore – if they did, why do the markets put a higher price on McDonald’s debt than the British gilts?
Likewise, in this country, as we know, huge tranches of government debt have been shifted off-balance sheet. The private finance initiative has become a vehicle for concealing how much the government is really borrowing. Pensions obligations are left entirely unfunded, for the simple reason that putting a cost on them would reveal how much the government will have to raise going forward. That is true of other countries just as much as it is true of the UK. Governments aren’t levelling with their electorates, and they aren’t levelling with the markets either.
Dishonesty is corrosive. The global banking system holds vast quantities of government paper. If it starts to suspect government debt statistics being are fudged, and the extent of indebtedness is being fiddled, suddenly no one is going to want trade it. It will be impossible to price the bonds. The whole market will freeze up.
By itself, the sovereign debt crisis would be a big enough problem. Fixing it would involve a lot of hard work, over many years. Governments would have to stop throwing money at electorates like confetti. Public sector employees would have to work harder for longer.
But add in contagion, greed and dishonesty, and it has the potential to turn into a re-play of the whole sub-prime debacle. Brace yourselves. Greece is just the start. This could soon get very nasty.

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