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Tuesday, October 4, 2011

Debt and Democracy

By Amy Erixon, Toronto, October 4, 2011

My 17 year old daughter came home with an interesting debate assignment last Thursday - to advocate “How Debt Destroyed Capitalism”. Not surprisingly, she was pretty confused by the number of contradictory opinions she had come upon in just a few hours of research on the internet.

Among the opinions she found were some of my personal pet peeves: Sovereign debt doesn’t count because governments can just print their way out of the problem…Bank debt doesn’t count because it’s possible to purchase credit default swaps to insure over those risks…and lastly, personal defaults don’t really matter because everyone is overextended days, lenders are incorporating this into their pricing (like that explains why your credit card company charges 14.5% interest while the government can borrow for around 2%).

I assured her that not everyone is defaulting these days; credit default swaps are not insurance; and sovereign debt counts just the same as other debts regardless of how much money is printed. Since all forms of debt compete for scarce resources, in an era of deleveraging what government elects to do or not to do really matters. We are finding ourselves in a world where increasingly instead of bankers deciding who will and won’t have access to credit it is politicians making those decisions, with a different set of criteria from traditional Capitalist rule-books.

In an interview yesterday on Bloomberg about widening spreads on Morgan Stanley credit default swaps, the interviewer kept talking about the increasing cost “of insuring” these bonds. The person being interviewed pointed out that the daily swap spreads are really more indicative of hedge funds betting on short term political risks the bank might be exposed to than underlying credit strength of the institution relative to its peers. This very technical discussion highlights Problem #1 – poor understanding of the role and array of contemporary credit instruments and Problem #2 - the proliferation of ways to bet on the market, and huge daily movements of capital which affect outcomes.

At a conference last week here in Toronto, an executive from JP Morgan was asked to explain why the modifications demanded by the rating agencies to their latest CMBS issue reduced investor demand for their product. His answer - the rating agencies are crunching numbers through a diversification test whereas investors are looking at underlying asset quality – fundamentally different approaches. He further noted - this explains why the US debt downgrade created such a rally in Treasuries. Which brings us to Problem #3 - Government regulator and rating agency seem to have lost focus on the fundamentals of repayment and long term viability of the borrower. I don’t like paying taxes any more than the next guy but austerity alone can’t produce the cash flow required to heal the government balance sheets. This seems as obvious as the nose on our face.

Much of what is currently being touted as a “debt crisis” is in fact, a political crisis - that is the inability and/or unwillingness to find palatable solutions that involve collective sacrifice to achieve collective outcomes. Because these discussions get instantly polarized into “winners and losers” they strike at the heart of what is undermining confidence that is so essential to smooth functioning of what is increasingly a global marketplace. In today's world we are all interconnected, the fortunes of the least impact us all. Since political risk is the hardest of all to gauge accurately, it’s no wonder markets are touching new lows.

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