`Sovereign debt crisis: What went wrong, what lies ahead

The global economy, particularly the global financial markets, has been reeling from sovereign debt crisis of a magnitude never experienced before. The wounds inflicted by the crisis is much more deep and painful as it emerged on the heels of the sub-prime mortgage loan episode of 2007-2008. The two crisis together have reshaped the global financial landscape. Simultaneously, there appears to be rethinking of the conventional and long held perception of investment risk and return with far reaching consequences for the capital market. The solution to sovereign debt crisis (SDC) has remained elusive for a long time. Despite a number of meetings even at the heads of government level, the Euro zone countries have failed to reach consensus on Greece's debt crisis. As Greece grapples with SDC, Spain, Portugal and Italy also face the threat of imminent sovereign debt problem. It now seems that the developed world or for that matter, the development banks therein, did not receive the early warning when Iceland's economy collapsed. Iceland with a history of stable and prosperous economy suddenly found itself in the midst of a severe banking and economic crisis which led to the dethroning of the Iceland government. Some European countries have been heaping up debt for quite some time. The four countries (Greece, Italy, Spain Portugal) had a very high ratio of debt to GDP, as shown below: 2000 2010 ( % ) Greece 103 45 Italy 108 118 Spain 59 61 Portugal 48 93 The countries of the EU are pledge-bound to comply with cap on budget deficit and debt-GDP ratio. But some states such as Greece and Italy could circumvent these ceilings and hid upward deviation. This was made possible, among others, by the use of opaque and complex derivative instruments mainly financial, currency and credit derivatives resulting in huge amount of debt which was not sustainable. Such countries were oblivious of the possibility that economic slump or recession can trigger severe disruptions. There was no serious efforts to tackle such high level of debt GDP ratio before the onset of the crisis. Debt burden grew to almost unbearable scale. These countries mobilised capital from international capital market by issuing sovereign debt (SD). Development banks in advanced countries, particularly in Europe and North America were the major purchasers of these debts. Countries have been issuing SDs since long. These are issued in foreign currencies backed by at least investment grade sovereign rating. Experience of SDs are mixed countries; some defaulted while others re-negotiated terms and conditions. The Greece saga has put the European Union's existence into jeopardy. Greece has to abide by the conditions and guidelines set by the European Union and by the European Central Bank (ECB). Its policy options are constrained by EU's overall policy The intriguing aspect of the whole episode is the apparent errors in judgement in evaluation of the SDs. Despite the fact that Greece, Italy, Spain and Portugal (GIPS) had been beset with problems, development banks and investment advisors, and investors treated them as strong as Germany and France. Till as recently as 2007-2008, yields on the sovereign bonds of Greece, Italy, Spain, Portugal, Germany and France were almost same (5.0 per cent). Only from the latter half of 2010, the bond yields of GIPS showed wide divergence with those of Germany and France. In the fourth quarter of 2011, the bond yields were 32 per cent-33 per cent for Greece, 10 per cent-12 per cent for Portugal, 6.5 per cent-7.5 per cent for Italy and Spain whereas for Germany and France were about 2.0 per cent and 4.0 per cent respectively. The movement of the yield spreads followed the same pattern. Yield spreads on bonds are an important indicator of corresponding country's strength. But the spreads on bond issued by Greece, a troubled economy, was same as on bonds issued by Germany, a stronger economy. The market's pricing of the bonds were faulty leading to serious implications. The amount of such bonds held by banks country -- wise are shown below; As on 30 June 2011, total foreign claims on GIPS in the form of debts, predominantly government debt, amounted to more than $2000 bn. In the credit default swap (CDS) market, CDS price also escalated steeply. The annual cost of protection of insurance on a $10 million Italian bond rose from $200,000 at the end of August, 2010 to almost $600,000 at the end of 2011. In case of Spanish bond, it went up from slightly more than $200,000 to nearly $400,000 in the same time period. As the possibility of default increased, so did the cost of protection against default. As the SDC unfolded, the roles played by the investment banks and rating agencies came under scrutiny. It is too well known that the investment banks in the developed countries fetched huge amount of income from commission, brokerage, advisory services, underwriting, etc. Despite the apparent mispricing of the bonds manifested in the bond yields and yield spreads, some reputed investment banks including Goldman Sachs, Morgan Stanley, Societe Generale were big underwriters of European sovereign bonds. The ever growing pursuit of fees and commission drove them to ignore prudence resulting in the underwriting decisions. The world's top banks' earned $113.9 million in fees in 2007 which shot up to $273 million in 2009. There is lately growing criticism that these banks are ruthlessly profit motivated with little or no concern for the long term interest of the financial market or of the investors. Complex and complicated financial instruments employing sophisticated mathematical and quantitative analysis are created and sold by them through astute presentation and marketing. The executives are awarded very fat bonuses and stock options for such purposes. Executives at the top banks earned total bonuses of $39 billion in 2007 as compared to bonus of $18 billion in 2003.Fees earned by the top five global investment banks are as follows : (In million $ ) J.P. Morgan 5533.85 Bank of America Merril Lynch 4581.59 Goldman Sachs 4386.52 Morgan Stanley 4055.48 Credit Suisse 3379.12 Most of the innovation revolves around various types of derivative products whose values are derived from other underlying assetssecurities. But ownership of such instrument does not establish ownership right on underlying assetsecurity. Derivatives are used mainly to hedge against risk while some traders adopt a purely speculative position or interest in derivatives. Many of such derivative products essentially relate to trading, arbitraging and speculating in risk of an investment. Any investment is basically risk - return trade-off. Risk has many varieties and features. Risk assessment and management models use highly technical tools. Mathematical analysis and computers are used to determine value price of such products. Sometimes a team of mathematicians and quantitative analysts is deployed to ascertain whether the value of the derivative instrument has eroded or increased after changes in the value price of underlying assets. Therefore risk based derivatives can be abused or misused to mislead investors. Generally, the more complicated the derivative, the higher the issue management and underwriting fee, and hence the enthusiasm for such derivatives. Well known and common derivatives are options, futures and swaps. Further derivatives are traded over the counter avoiding clearing and settlement mechanism so that the identity of the traders can be concealed. There is no denying that derivatives are quite useful in managing systematic and specific type of risk through hedging strategies, if they are use judiciously, properly and if they are well - intentioned. But it is also true that these are prone to abuse. Opacity of the derivatives accompanied with lack of transparency and lax disclosure can result in under pricing of risk leading to credit boom and escalation of systemic risk. Turmoil in the financial world in the recent past demonstrates that there have been cases of abuse. The use of derivatives to hide credit risk from third parties gave rise to the crisis of 2008 as well as the SDC. Warren Buffet, the world's most celebrated investor, managing assets of more than $40 billion, termed the derivatives 'weapons of mass destruction'. With regard to SDC, it would be pertinent to dwell on Credit Default Swap (CDS). Simply put, CDS are insurance - like products that promise to cover losses in case of default by a particular company or business. The buyer of CDS pays premium to the seller over a period in exchange of a guarantee of receiving full payment in the event of default. In other words, CDS are bet against default. The greater the chances of default, the higher the premium. Some contend that the CDS market prosper on speculation, at times excessive speculation, to the detriment of the market and the investors. Sceptics opine that CDS market may have encouraged the unbridled issue of debt securities which later turned out to be very burdensome. The world's largest insurance company -- American International Group -- incurred its largest loss in its history due to write down of $11billion on its CDS holdings. The growth of the derivative market is staggering, increasing from $100 trillion at the end of June 2001 to about $520 trillion at the end of same month in 2007. On the other hand, The CDS market was a $45 trillion market in the mid - 2007 which was almost double the size of the US stock market (nearly $22 trillion) in mid- 2007. One could be inclined to suggest that CDS may sometimes cause over-speculation on the possibility of default by a country thus hurting its economy and tarnishing its credibility in the international capital markets. For some European and US banks the current crisis has been a very bitter experience. After digesting huge losses on account of sub-prime mortgage loans, these banks replaced those loans with the sovereign bonds on the belief that the sovereign bonds would be fully risk-free. But the crisis has now revealed that these can also be risky and turn bad. Sovereign debt problem is nothing new. In fact in the 1300-1799 period France and Spain defaulted on external debts eight times and six times respectively. Then, in the 1800-1899 period, Spain defaulted on external debts eight times, Greece four times, Portugal and Venezuela six times each. But the on-going SDC inflicted a deep scar due to globalisation, integration of financial markets and cross-border capital mobility. The current SDC in combination with its predecessor, sub-prime mortgage crisis are likely to bring about fundamental and far-reaching changes in the field of theoretical and operational finance as follows; (1) The conventional risk-return analysis is founded on the basic premise that while equities are most risky, debt securities such as bonds carry very little risk and within bond class, sovereign bonds are risk-free. When equities enter into bear spell, investors are found to flee to the relative safety of bonds and sovereign bonds. But the SDC tends to dramatically alter this perception since sovereign bonds have now been discovered to be risky. Bonds cannot be relied on as risk-free or low risk asset in certain situations. In the new perspective, asset allocation in a portfolio may become a more strenuous and tricky job. Gold and other precious metals and real estate may receive greater attention in asset allocation. Symptoms are already evident in the surge of price of gold. (2) Portfolio diversification may be more arduous. Increased allocation to bonds in a bid to minimise risk may not produce the desired goal as bonds can be risky as well. We have learnt from the sub-prime mortgage crisis that in times of recession, industriessectors move in the same direction generating high correlation among all industrial sectors with the consequence that a broad-based portfolio having stocks of different industries cannot reduce risk to the desired degree. The SDC has rendered diversification much more difficult. (3) Accounting standards may undergo basic changes. In some countries, particularly in Europe, banks are not required to set aside additional capital for sovereign bond holdings but banks may now be asked to do so. If holders of Greek sovereign bonds accept haircut i.e. write down on these holdings, the need for such capital cushion will be reiterated. This could be a key factor in the current initiative of convergence of the accounting standards of Europe and USA. (4) International debt market is likely to undergo significant structural shifts. Appetite for debts including even sovereign debts may decline, at least in the near future. Sovereign bond has so far been the most convenient, low-cost and expedient way to raise the much needed fund. But the recent SDC has upset this advantage. In the very recent past, a bond issue by Germany received lukewarm response unlike in the past. On the other hand, banks and other financial institutions will find it very tight to issue debt for various purposes including recapitalisation. For weaker euro zone countries, the cost of raising money through sovereign bond has gone up. Since the beginning of the SDC, yields and yield spreads on bonds of weaker countries have been going up as investors insist on higher risk premium. The reversal of this trend is not expected any time soon. As the borrowing cost goes up, so does the debt servicing liability. (5) As the banks and financial institutions laden with bad debts mobilise more and more capital to strengthen their balance sheet and at the time cut lending, companies have very little access to loans because of the "crowding out" effect. This tends to diminish national output with a negative impact on GDP. (6) The problem-ridden countries have decided on strict austerity measures, among others, to tackle the crisis. Growth may suffer as a result because austerity measures would curtail consumption which is a prime driver of growth. Notwithstanding the adverse impact of the crisis, there are reasons to be optimistic. The SDC has reinforced the need for overhaul of the financial system without any further delay and a raft of measures and actions have been initiated. In USA, the now famous Dodd-Frank act contains a series of new rulesregulations to ensure greater transparency, wider disclosure, stricter oversight, rigorous diligence and forceful protection of investors and other stakeholders in the market. A number of new institutions and agencies will be created under the act to police the market. Transactions in the vast derivative market will be shifted to the clearing houses to be established for the purpose. Tax may be imposed on the holdings of derivative products by banks and other financial institutions. There are proposals to put cap on derivative position of a trader on a single day. Executive compensation including bonuses have to comply with prescribed guidelines. A financial market thrives on new products and instruments arising out of creativity, innovation, and new ideas, but these must be well-meaning, simple and straightforward providing all required disclosure and descriptions to ensure market's real purpose and integrity. Investors and other participants pin their hopes on financial markets which must function on a sound and solid footing to win their trust and faith. The writer may be reached at email: zia5577@yahoo.com