On the Reliability of Price Signals
So over this past weekend, while blissfully out of touch and enjoying the sun and the Pacific, apparently Spain got bailed out. Or at least, its banks were bailed out. Spain “paid” for the bailout through a loan extended to it by “Europe” – in this case the European Stability Mechanism (ESM). All agree it was a wonderful thing, handled totally smoothly. The ESM had previously allocated a hundred billion or so for Spain, so the optimistic case is that that they were correct in forecasting the weak spots in the European financial system and have the cash ready on hand. Movements in the bond markets agitate against the optimistic case, but who knows.
Dealbreaker argues that the movement actually reflects the fact that the ESM “bailout” was in fact below-market senior debt, demoting regular ol’ bondholders to junior status. If you had anything less than 100% rock-solid confidence in Spanish debt, which is scarce at the moment, the subordination of the bonds you own should materially decrease its value. In fact, it goes further into the minutiae of whether or not the deal should count as a debt restructuring and thus trigger credit default swaps (CDS) on Spanish debt.
Regardless of whether or not the CDS are triggered in this case, this just goes to show that a lot of the risk-management tactics applied to the sovereign debt market are fundamentally broken. CDS allows debt-holders to “hedge” against debt by promising a payout for a credit event. Bank collapses in 2008 showed counterparty risk – what happens if the CDS issuer (AIG) goes bankrupt? The current issue with Greece and Spain is that the people that are judging for “credit events”, the ISDA, is manned by people who are up to their balls. Turns out the risk mitigation which was supposed to make everything happy and wonderful was just papering over the very real downside risks involved with sovereign debt – if the people who write the laws don’t feel like paying their debts, good luck suing for recovery.
Since all debt risk is generally keyed to the baseline of “the government is the least risky entity in a given polity to lend to”, this suggests that debt across the world has been generally, let’s say, optimistically priced. Perhaps the developed world as a whole may be overleveraged?