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Sun 11 Jul 2010 04:00 AM

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Is default the best exit strategy?

With global financial markets still in a state of disrepair, investors are wise to tread softly, says Mark Gilbert.

Is default the best exit strategy?

The notion that default might be the only sensible exit strategy for an indebted euro nation is finally gaining traction with the authorities. With global financial markets still in a state of disrepair, investors would be wise to tread softly amid the potential nightmares.

A draft European Union document, dated June 25 and scheduled for discussion July 12-13, was obtained by Bloomberg reporter Meera Louis. The draft suggests the forthcoming stress tests planned for the region’s banks should assess the dangers posed by “exposures to sovereign risk.”

That’s a euphemism for asking whether banks would blow up if a government couldn’t pay its debts. Including that scenario in the analysis is an admission that the prospect of restructuring has, in the minds of the euro’s apparatchiks, moved up the scale to “possible” from “out of the question.”

On June 28, the Bank for International Settlements weighed in with its annual report. Cheery reading it is not. “As the long history of sovereign debt crises has shown, when investors lose their confidence in a country’s ability to service its debt and become unwilling to hold it, rescue packages, bailouts and even debt restructuring for the sovereign remain the only options,” the BIS said. Rearrange the words “bag,” “cat” and “out of the” to form a well-known phrase.

Financial markets breathed a huge sigh of relief last week when a money auction by the European Central Bank seemed to suggest that bank funding pressures aren’t as bad as they might have been. I’m certainly not convinced.

Sure, it looks like good news that banks didn’t feel the need to re-borrow all of the €442bn ($539bn) that they took from the ECB a year ago and have to repay. In three months, however, we’ll replay the same, nervy game when Europe’s financial institutions have to find the €132bn the central bank loaned them last week. A problem delayed is not a problem solved.

Maybe the banks don’t need the cash because they’re not planning to do anything with their money other than keep it stuffed in the holes in their balance sheets. If you’re not lending to the bank next door, or to the entrepreneur trying to build a business, or to your own profligate government by investing in its bonds, maybe you can afford not to turn up at the ECB’s money auctions. That’s not a good thing.

There’s a terrifying chart on page 32 of the BIS report. It suggests the average maturity of bank debt around the world has declined to about 4 1/2 years, down from a 30-year average of more than six years. And those are last year’s figures; the trend would suggest that refunding risks are probably even higher now.

The BIS, which acts as kind of a clearing house for central banking philosophy, reckons debt is coming due at the fastest pace in 30 years, and that 60 percent of what it calls “long- term debt flows” need repaying in the coming three years.

So Europe’s banks have transformed a one-year obligation of €442bn into a three-month burden worth €132bn. That should give pause for thought. The same logic applies to the euro region’s governments, which aren’t exactly flooding the zone with 30 and 50-year debt.

“The vulnerability to a run on debt is clearly higher when a country has to refinance a large portion of its debt every year,” as the Basel, Switzerland-based institution put it.

Three warnings in particular stick out from the BIS report: that ultra-low central bank interest rates are dangerous; that policymakers have no capacity to cope with the next black swan; and that government coffers are out of firepower to fend off any renewed attack on the banking system. Suppressing borrowing costs to near zero “alters investment decisions, postpones the recognition of losses, increases risk-taking in the ensuing search for yield, and encourages high levels of borrowing,” the BIS wrote. That’s exactly what caused the credit crisis in the first place; so we should be “extremely wary this time around,” the report says.

When governments and central banks distort markets, bad things happen. As risk has drifted from bank balance sheets to government accounts, the medicine cabinet has been raided again and again to try to heal the global economy. “It will be difficult to find a source of further treatment should another emergency arise,” the BIS said.

The BIS’s final caution has an air of unreality. “If the debt of the government itself becomes unmarketable, any future bailout of the banking system would have to rely on external help,” the agency says.

External help? If the capital markets are closed to governments, it is far from clear what external sources might remain available to banks in trouble. They can’t exactly ask the International Monetary Fund for help. Recent government-bond auctions in the euro area tell you nothing about the willingness of investors to fund government deficits.

Arms will have been twisted so far up backs that the domestic banks obliged to participate in the sales couldn’t reach the “No, thanks” button without breakages.

In the absence of a clear picture of sovereign-debt demand, market participants would do well to heed the weekly words of sergeant Phil Esterhaus as he sent the police officers of “Hill Street Blues” out onto the streets: “Hey! Let’s be careful out there.”

Mark Gilbert is a columnist for Bloomberg News. The opinions expressed are his own.

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