COULD SOVEREIGN DEBT BE THE NEW SUBPRIME ? / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Could sovereign debt be the new subprime?

By Gillian Tett

Published: November 22 2009 18:33

A few weeks ago, Claudio Borio, head of research at the Bank for International Settlements, warned in a solemn note to Group of 20 leaders that modern financial policymakers are “driving while just looking in the rear-view mirror”: western finance officials have focused so much on past risks that they fail to spot new dangers.

Worse still, as policymakers rush to implement reforms in response to one financial calamity, they are apt to create distortions that pave the way for the next disaster. Just such an unintended consequence could now be festering in the banking sector, as its balance sheets are increasingly stuffed with government bonds.

These days, there is a near-unanimous belief among western regulators that one way to prevent a repeat of the 2007-08 crisis is to stop banks taking crazy risks with subprime mortgage bonds or complex instruments such as collateralised debt obligations (CDOs). Instead, banks are being urged to hold a higher proportion of their assets in the form of “safe” instruments, most notably sovereign or quasi-sovereign debt. G20 regulators are holding regular meetings in Basel to draw up rules on how banks should do this, as part of a wider reform of financial regulation.

In theory, that move sounds very sensible. One reason why large banks crumbled last year was that many were carrying vast quantities of highly rated CDOs and other toxic paper. These not only lost their value during the crisis, but also became impossible to trade, creating a liquidity shock for the banks.

Government bonds, by contrast, remained liquid during the recent crisis (and have been so in the past few decades). So it appears appealing to hold more of them, particularly given that sovereign debt is also widely presumed to be ultra safe; so safe that the yield on government bonds is known as the “risk-free rate”.

But could this flight to the “safety” of government bonds in itself be creating subtle new dangers? Government debt, after all, has soared to levels not seen in peacetime for centuries, if ever, in many countries, not least the US and UK. Fiscal deficits are swelling across the western world. And the level of political commitment to curbing those deficits remains uncertain – not least because with yields currently so low there is less pressure on politicians to push through reform.

That does not necessarily mean an outright default looms any time soon; indeed, default seems highly unlikely. However, it is easy to imagine that some countries will end up eroding the value of their bonds by debasing their currencies in the coming years, printing money and stoking inflation.

It is even easier to anticipate a sharp rise in bond yields – and a corresponding sharp fall in bond prices – particularly when central banks stop their quantitative easing programmes. Some smart hedge funds are betting on just that.

Yet there has been precious little debate about whether banks should keep loading up on sovereign debt. In Sydney, some Australian banks are grumbling about the Basel liquidity reforms. Ironically, that is because Australia is in the rare, happy position of having low(ish) debt levels, and its local banks fear they will struggle to find the bonds they need to meet the new G20 liquidity rules.

In countries where there is likely to be a surplus of government bonds for sale, there is little public discussion at all. Perhaps that is because the banks do not wish to rock the boat; or maybe central banks themselves do not wish to draw attention to the swelling volumes of government bonds they now hold themselves.

Finance ministries are hardly likely to complain about the banks’ investments. Major industrialised countries will need to sell more than $12,000bn worth of government bonds this year and next to fund their fiscal hole. This is a rise of at least a third, or $3,000bn, in just two years.

As Mr Borio notes, focusing only on that rear-view mirror is dangerous; whatever causes the next banking shock, it will not be mortgage CDOs. So I, for one, fervently hope that those banks holding government bonds are being cautious enough to hedge themselves against any future crash in their price; so too, for those holding quasi-government instruments, such as agency bonds.

I also hope that when the Basel regulators finally produce their new liquidity rules, the banks will have to build in a significant margin of error to reflect a potential fall in government bonds. This would underline the point to both banks and investors that government bonds are not automatically “risk-free”. Most important of all, though, I hope that the current calm in sovereign debt markets does not lull politicians into thinking that they can indefinitely avoid the need to take difficult fiscal choices. For if they do, those “safe” government bonds might start to look considerably less secure – not just to bankers, but to everybody.

The writer is an FT assistant editor

Copyright The Financial Times Limited 2009.