Sovereign Debt: a Threat to the Entire Financial System

Sovereign Debt: a Threat to the Entire Financial System - Bill Bonner → … al-system/

“the debts of Ireland are the credits of French and German banks”
Well, it’s not really true.

More than half the bank debt of the six guaranteed banks is held in Ireland. A fair proportion of sovereign debt is too. In any case, it is not banks themselves that are holding this debt. It is individuals (whether directly or through funds) who are. It is German pension funds, whether institutional or individual and the same in France. Banks just don’t need to buy outside their country. Irish sovereigns cost more than the equivalent German and French ones until they cost waaay less and it was clear Ireland was bust. Even Michael Lewis’s Hans in Frankfurt wasn’t that stupid that he couldn’t read the FT Deutscheland.

What is more concerning is contagion to a class of security, both sovereign and bank. Banks in Europe appear to be stuffed with cross-collateralised bonds - they’ve bought lots of each other’s senior debt, perhaps in cosy deals, but who knows. Anyway, the effect is to leave the banking system like the one in Japan - everyone owns a bit of everyone else’s debt. As bank has defaulted on senior debt or even haircut it for a very long time, it has been considered ‘money good’ - as good as sovereign debt, as good as cash. Which means they can be counted towards capital ratios. When banks started to go bust in Japan, they owed other banks money, which they couldn’t pay. More damaging, though, was the fact that suddenly bank debt was no longer risk-free. This meant that the price started to fall as risk premia rose (say you’re an A rated bank and previously your bonds were worth 100 to other banks that had bought them from you - suddenly they’re only worth 95, suddenly that bank is teetering on the edge of solvency…

So, you are all standing around the slurry tank that is the Irish banking system, peering in with your noses just above the water and arms interlinked. Someone gives one of you a push… what happens the rest?

And then we come to sovereigns. Not since 1948 (IIRC) has a currently in the eurozone state defaulted. It just doesn’t happen to first world rich countries, that’s what helps keep their bond rates low. That and the Maastrict criteria. But what if the important criteria isn’t the deficit figure? What if it is the debt figure? What if Reinhart and Rogoff are entirely right and that once you go over 80% you are in trouble, and once you go over 100% you are stuffed? What if european sovereigns aren’t risk-free? What would that do for the funding of european countries? What would an increase in funding costs do for the likelihood of default?

So, in a long-winded way, my point is that it is not the flow of cheap money that is the problem. IT IS NOT A LIQUIDITY PROBLEM. It is a the value of the assets. IT IS A SOLVENCY PROBLEM.