Pillar of the regulatory structure looks wobbly

When future financial historians look back at the early 21st century, they may wonder why anybody ever thought it was a good idea to repackage subprime securities into triple A bonds. So, too, in relation to assumptions about the "risk-free" status of western sovereign debt.

After all, during most of the past few decades, it has been taken as a key axiom of investing that most western sovereign debt was in effect risk-free, and thus expected to trade at relatively undifferentiated tight spreads. Now, of course, that assumption is being exposed as a fallacy. Just look at those Greek haircuts, or the scale of future losses now being implied in the credit derivatives markets for Portugal, Ireland and Italy.

David Fuller's view If you think about it, the term 'risk-free debt' is an oxymoron. How can debt be risk-free? It is a financial obligation which even the sovereign borrower cannot guarantee to redeem in real (inflation-adjusted) terms and in a stable currency.

Credit worthiness may have been assumed at the time of borrowing but this can and sometimes does change over time. People will point out that governments which control their own money supply cannot go bust because they can always print more to redeem their debt. Yes, but that is partial default by inflation, resulting in a loss of purchasing power. In extreme cases such as Zimbabwe, the currency is rendered worthless and no one will lend to the country.

The fantasy of 'risk-free debt' also creates a moral hazard for the borrower. If a sovereign borrower is regarded as risk-free, it will be tempted to borrow with impunity, well beyond its assured means. After all, the debt can always be rolled forward, albeit at a cost as creditors eventually demand a higher yield.