Moral Hazard?

Crossposted from The Stars Hollow Gazette

What’s that?  Never heard of it.

The eurozone’s terrible mistake

Felix Salmon, Reuters

Dec 5, 2011 23:36 EST

The FT is reporting today that the new fiscal rules for the EU “include a commitment not to force private sector bondholders to take losses on any future eurozone bail-outs”. If this principle really does get enshrined into some new treaty, it will be one of the most fiscally insane derelictions of statesmanship the world has seen – but it certainly helps explain the short-term rally that we saw today in Italian government debt.

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To understand just how stupid this is, all you need to do is go back and read Michael Lewis’s Ireland article. The fateful decision in Ireland was to take the insolvent banks and give them a blanket bailout, with the banks’ creditors all getting 100 cents on the euro. That only served to put a positively evil debt burden onto the Irish people, forcing a massive austerity program and causing untold billions of euros in foregone growth, while bailing out lenders who deserved no such thing.

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The worst case scenario is that the EU kicks the can down the road with one new bailout facility after another, until it eventually gives up throwing good money after bad and imposes the restructuring which was inevitable all along. In that case, as one hedge fund manager was explaining to me last week, private sector creditors get devastated: because the EU and the ECB and the IMF won’t take any losses on their loans, all of the haircut, pretty much, will have to be borne by a private sector which accounts for only a fraction of the debt. So the private sector could end up with very, very little indeed.

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The immediate result of this plan is that everybody will rush into the highest-yielding bonds in Europe, which is exactly what seems to have happened today. The other effect of the plan, however, is that every country in Europe is now effectively guaranteeing everybody else’s debt. Which is more than sufficient to explain why S&P is minded to downgrade every country in Europe, up to and including Germany.

In order for markets to work, lenders need to suffer when they make bad lending decisions. If the Europeans didn’t learn from Ireland, couldn’t they at least learn from the Fed’s much-criticized decision to pay off all AIG creditors at 100 cents on the dollar? Blanket guarantees at par are pretty much always a really bad idea – and this one, if it comes to pass, will be the biggest one yet. It won’t end well.