Risky Business

In today's day and age, suppose a Government that has trouble meeting its debt obligations were to simply repudiate them? Now there is some historical precedent for this, the French Monarchy did it a few times, and oddly, they were still able to borrow money. However, in today's market what would it mean?

Clearly, anyone who had lent money to that particular country would lose most if not all of that money. It is of course also possible that various insurance and/or equity markets who had bought or sold risk mitigation for that country would also lose money. In fact, it is more likely that that is where the main damage may occur.

If you think back to the Lehman's Brothers bankruptcy, it also threatened many other firms because the Lehman default's triggered insurance payments. AIG would have been unable to cover their obligations had the Government not stepped in. I haven't done enough research into all the sovereign debt out there, but I suspect many lenders have purchased some sort of insurance to offset possible losses. Further, we most likely have speculators who have purchased instruments that will pay if certain countries default, even though they have no personnel exposure.

This was one of the odd things about the latest financial crisis. Many of these derived financial instruments have become so complex, that very few people really understand all the implications. To some extent they are lottery tickets, sold cheaply on the premise that there will never be a real payout. It is nearly impossible to truly calculate the risk of a sovereign default. Also what is a true default?

Before our current level of sophistication, a sovereign nation could unilaterally make changes to its debt structure and lenders, could sue or live with the changed circumstances. So, when Dubai had its issues a few months ago, it could have simply suspended all payments for a period of time and allowed interest to accumulate until some of the expected income materialized. Of course, this would have dried up Dubai's ability to raise money, but then again maybe not. What it would have done in today's environment is kick off all the default clauses and provisos in all the derived securities that bet for and against that event.

It is likely that since that would be considered a default, payouts would be due even if later all the original debt was repaid at the agreed to interest rate. Clearly, for certain traders, this is a no-lose situation. Of course the insurance reduces their initial returns, and if there is never a default, that money never has a payoff. However, when the lottery does payoff, it really pays off.

For those on the other side of the equation they assumes large liabilities with what they believed to be very low risk, ergo why they get paid so little. If they do have to payout, i.e. Lehman Brothers there is significant risk they won't be able to. Now, allowing institutions that hold assets for pension funds and other depositors to take these risks with company wide exposure is, well, foolish. The fact is that if they lose that bet, they will end up liquidating assets that should have been reserved for those who trusted that institution.

Prohibiting institutions that have any sort of Government regulatory oversight to engage in both behaviors is simply wrong, unless the risky business is shielded.