As the Greek drama continues in global bond markets, we are struck by the suddenness of investor recognition that sovereign obligations aren’t risk-free. In 1672, Charles II stunned England’s investors when he issued the infamous “Stop Order,” that did just what the name implies. Widows and orphans went begging as their gilts became worthless. Bankers and regulators might be forgiven for forgetting the lesson of 1672, but not for blithely ignoring all those that followed.
The most recent of these was a scant two decades ago, when Citibank and many others would have faltered, if not failed altogether, as nation after nation walked away from its obligations to global investors. After that crisis, banks learned the hard way not to lend too much money to sovereigns. They and the regulators just didn’t remember thereafter that credit risk is credit risk and, when it shows up in bonds or CDS, it’s just the same as when it’s in a simple, old-fashioned loan.
The 1980s crisis was called the LDC one after the less-developed country moniker then applied to deadbeat nations. Now, more politely, they are called “emerging” nations, but the risks remain the same. Indeed, they are even greater now than in the 1980s because some of the riskiest sovereign debtors are treated in global markets as if they had fully emerged. This means that bankers take representations at face value from countries like Greece they would never buy from Russia or China, let alone a really-emerging country like Chad. As a result, they assume that the presumptively-emerged sovereign entity is good not only for traditional debt, but also for CDS – including naked ones.
Bankers weren’t alone in ignoring sovereign risk, of course. Regulators were also – yet again – blindsided. One reason regulators were lulled into complacency as the biggest banks renewed their profligate ways was that banks took risk in unprecedented fashion. Sovereign risk was part of the panoply of complex, off-balance sheet and uncapitalized risks banks took without hearing boo. For, while banks had ceased lending more than their capital could support in the wake of the LDC-debt crisis, they were putting themselves and their sovereign customers at risk through ever more complex structured-finance deals.
How did this happen? First, regulators didn’t understand the risk and, when they thought they did, they looked the other way because, as Alan Greenspan famously hoped, derivatives were thought to disperse, not concentrate it. The wonder of derivatives was, they thought, that risk essentially vanished.
Second, simple, straightforward credit-risk analytics were ignored because the rating agencies saw no risk worth noting. Third, accounting rules permitted complex structures to be booked as sales, not loans, hiding their risk.
All of this is all too familiar for private participants in the financial-market’s collapse. But, sovereigns have a unique feature – they are sovereign counterparties and, thus, immune from creditor demand or capital calls. Banks can try to assert contractual claims against sovereign counterparties (although none to our knowledge did). But, even then, enforcing a claim against a sovereign is notably difficult, as banks should have learned when they tried this the first time after the LDC-debt disaster.
The only way to enforce a claim against a sovereign is through treaty rights enjoyed by other nations that then act on behalf of their banks. No such treaties existed in the LDC debacle, but the European Union is governed by them. As a result, the EU is working feverishly to come up with a solution that rescues Greece, Portugal, Spain and, perhaps others. Failing to do this could not only throw some of the world’s biggest banks back over the brink, but also threaten a fundamental political premise – the ability of the European Union to stand together as an economic and single-currency supranational.
Thus, the sovereign financial calamity is not only a sad repeat of past failures, but also a new form of systemic risk. When nations are counterparties, their fate stands at risk along with those who proferred the financial instruments that promoted their profligacy, just as occurred when England’s bankers went bust after the Stop Order. But, when bankrupt nations are part of a larger global structure like the EU, they also put even more prudent nations at risk, endangering the European Union as a whole. Systemic risk, indeed.