US Sovereign Credit Risk and Inflation

By Howard Simons Feb 08, 2010 10:00 am

We're going to see a struggle between governments and their creditors play out in 2010.

When future economic historians look back on the global credit crisis starting in February 2007 with HSBC’s (HBC) disclosure of subprime mortgage losses in its Household Finance unit and reaching its spectacular climax in September 2008, they'll wonder why someone thought it was a good idea to place bad private debt on the public’s books.

The losses had occurred already; they happened during the misallocation of resources during the housing bubble. The bust simply was the accounting. No amount of financial engineering or deal-making by an investment banker turned Treasury Secretary could undo what had been done. Until and unless the losses were recognized, the sooner the better, the markets couldn't clear by placing assets at fire-sale prices into newer and presumably stronger hands.

The only thing all of the bailout programs did in the US and around the world was encourage the leveraging of the public sector as a way of offsetting the deleveraging of the private sector. As a result, governments around the world are saddled with the residual losses created by the bust, and as poisons remain toxic until neutralized, public finances increasingly are in shambles. Greece, Portugal, and Spain may have grabbed the headlines last week, but if the US keeps running deficits on the order of the proposed $1.6 trillion, we'll be there soon enough.

All current traders know your first loss is your best loss. Those who don't figure this out in time are, by definition, former traders.

Flight to the Printing Press

On February 23, 2009, the Federal Reserve and Treasury announced what amounted to a statement that no more major financial institutions
would be allowed to fail; implicit in this statement was they'd print the money to backstop the banks and, if necessary, to honor the Treasury’s debt issued in the process. This arrested the increase in credit default swap costs on Treasuries. TIPS breakevens (plotted inversely), a flawed measure of inflationary expectations, lead 10-year CDS costs by 39 days on average.



We can summarize the period before September 2, 2009 (green line) as, “a little inflation is welcome in the CDS market.â€