Sovereign Default Risks
Research for Online Investors

by John Dalt

12/01/10

Ireland has been in the news for the last three weeks as the confluence of politics, budgets, bonds and investors tugged at the loose strings of the eurozone credit markets.  All of the analysis and reporting may leave some questions about the why and how of sovereign debt problems.  I received the following questions from a subscriber, and thought they may be of greater interest.

Casualty and bonding companies 'bond' building contractors to cover bad workmanship.   But they never deliver, not on a leaking flat neoprene roof over a gym, not on sewage leaks or anything.  Yet, as a contractor I had to pay them every year, like a bribe, or I could not bid on work.   Aren't CDO's the same?   Why not just let these bonds default and the CDO's would cover it.  What's up there?-subscriber A.C.

The bonds issued on construction projects are for completion of the project to specs, and that the contractor will fix any workmanship issues during the warranty period.  The bond issuer will honor their "bond" if the project owner turns to them because of unsatisfactory work, if the contractor will not honor the contract.

This bond insures the project for the owner not the contractor.  If you do not do your job and the bonding company has to "step in" to complete your job or warranty, you will never get bonding again.  For this reason, bonding companies are rarely called upon to complete or warranty a job, unless the contractor is bankrupt.

This is why bonding companies are very interested in your financials...do you have the assets to weather a loss?  CDO's are the same.  This is what got AIG in trouble.  They issued CDO's but didn't check the assets.  A CDO is like bonding, they are a low risk product for the bonding company if carefully priced.

If a country let's bonds default and the CDO's pick up the loss...who would insure their future debt?  Without insurance (CDO), banks and other investors could not buy if they are regulated (required) to have protection in place.  Also, what credit rating agency would issue a favorable opinion on a new bond issue after a default?

We can think of this like a personal bankruptcy.  I have no firsthand experience, but understand it can affect your credit and ability to borrow money for years after the event.  What country could go for five years or more without access to credit?

When is a default not a default?  When it is sovereign debt? Why not just give all governments an unlimited credit card from the Federal Reserve? After all, the banks have that.---A.C.

A default of any debt, sovereign or personal, is met with penalties.  You may be in bankruptcy court where assets are divided, payments to creditors can be restructured, and the result is always destruction of your credit rating.

The U.S. government and banks do indeed seem to have an unlimited credit card.  I hardly think the Federal Reserve is willing to extend the same coverage to Ireland, Portugal or Spain.  But these issues are why Rep. Ron Paul has asked for an audit of the Federal Reserve.  Has the Federal Reserve bought foreign debt?

The market is up big this morning. This is as unreasonable as the big fall yesterday. Discipline seems to be in short supply. Spain plans on selling three year bonds tomorrow. Does anyone think that will go satisfactorily? Last week’s auction of three and six month notes saw interest rates almost double.

Will the “Bush” tax cuts be extended, or expire?  What about unemployment insurance, will it be extended?  Will U.S. budget authority be extended, or will the government shut down later this month?  It seems a lot can go wrong in the next three weeks.

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Quote:
Conservative, n: A statesman who is enamored of existing evils, as distinguished from a liberal who wishes to replace them with others.---Ambrose Bierce

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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