2008 Redux: The 2011 Crisis of the Interconnected Sovereign Complex

By Peter Atwater Whether it is global leaders, foreign financial institution executives, rating agency professionals, or investors, they are all reading from the same 2008 playbook. Mark Twain was wrong. History really does repeat. Looking at the financial headlines over the past week, it is 2008 all over again, only this time with names of people, places and financial institutions that are harder for most of us to pronounce. It's the same disease only in a different (and far bigger) patient. Substitute the wording of Moody's Friday night ratings warning on Italy with Citigroup C and it could be August 2008. Swap money market funds and municipal bonds with adjustable rate preferred stock and variable rate notes and it is the fall of 2007. And replace BNP Paribas SA and its San Francisco-based unit Bank of the West with Lehman Brothers and Neuberger Berman and it's September 2008. (To read Professor Pinch's thoughts on the broken tech sector, click here.) Whether it is global leaders, foreign financial institution executives, rating agency professionals or investors, they are all reading from the same 2008 playbook. Leaders want time; bankers want capital; the agencies want calm; and investors just want out. We have once again reached the point where everyone knows that the problem is solvency, not liquidity. And in an interconnected, interdependent, global financial/sovereign complex – or what I now simply call the “interplex” -- where everything is somehow a derivative of something else (and vice versa), it is just a matter of your degree of impact. Earlier this year, one could see the interconnectedness of sovereign ratings as country downgrades triggered in rapid succession the downgrading of foreign financial institutions and then those institutions' covered bonds. But that was when sovereign ratings were still largely Aaa and Aa. With country debt ratings now deteriorating even further (both in quality and I'd offer more importantly, quantity), and sovereign “willingness and ability” all the more precariously situational, the consequential ratings ripples have become a literal tidal wave of downgrades as the rating agencies consider the widening collateral and cross-collateral consequences. Three weeks ago, for example, not 24 hours after putting Japan's Aa2 sovereign debt rating on review for possible downgrade, Moody's put “Japan Inc.” on review, watch-listing more than 70 banks and bank affiliates, 15 public companies, including the country's major railroads, electric, gas and telephone utilities (not to mention Toyota Motor Company TM), 12 regional and local governments, five Aa3-rating companies including FUJIFilm Holdings, five bank-affiliated non-bank finance companies, and 13 Japanese “agency” issuers, including Japan Tobacco and NTT. And those are all what I would consider the obvious “first derivative” ratings impacts. In time I expect that Moody's will also need to consider the thousands if not tens of thousands of individual “second derivative” exposures -- securities and other financial relationships some way supported by these now-on-watch institutions. (To read Steve Shobin's market predictions, click here.) As in 2008, though, the more global leaders attempt to delay the consequences in an effort to stem the tide one institution at a time, the more they raise the risk of outright contagion. Time is no substitute for capital. And as we saw in 2008, markets wait for no one. Worse, particularly this go-around, we have now learned that a global leader's word is only as strong as the willingness of her voters to follow. Losses must be taken, and as I have written before; it is now all about the re-syndication of that loss and to whom the burden is shared. And therein lay the real problem to this 2008 Redux. At the risk of over-simplicity, 2008 was a national banking crisis with international implications. The burden was principally shared among US financial institutions (their creditors and shareholders) and US taxpayers. And while historians will forever debate the outcome, a very small group of national leaders made decisions based on what they believed was in the best interest of their country. In contrast, 2011 is a developed-nation sovereign debt crisis with pronounced global implications; and the complexity of the burden-sharing decision-making process is far greater than anything we have witnessed in our lifetime. How and to whom losses will be shared cuts across sovereign borders, public and private sector boundaries, national and supra-national divisions and social strata. And that is just at a primary level. As this week's headlines reveal, investors are just beginning to grasp the enormity of the second derivative impacts (for example, money funds and municipal bonds). And I'd offer that those are just the most obvious. Wait until people start to wonder what all that “cash” on corporate balance sheets really is (and might I suggest where it is) or how Tier 1 Capital is impacted by deteriorating sovereign debt ratings. Welcome to the interplex. The real challenge European leaders now face is how best to choose the least bad burden-sharing solution in a world in which the willingness and ability of both the weak and the strong to take losses is on a rapid decline. And while I wish it were not the case, given its multiple dimensions (financial, political, social), to these eyes the notion that a “fair” and “orderly” burden -sharing of the losses can be achieved seems woefully naïve. Some one will “unfairly” lose, and worse that someone will know that his loss was to the benefit of someone else. (To read a comparison of Amazon and Wal-Mart, click here.) During the 2008 banking crisis, I offered that the challenge policymakers faced was akin to trying to dismantle a house laden with interconnected explosives one room at a time without attracting the attention of the neighbors. This crisis is more akin to a whole city, and unfortunately rather than trying to keep things quiet, policymakers seem only too happy to stake out their individual positions on TV, in the financial press and even Twitter. They've now got our attention; but whether policymakers can safely disarm the interplex remains to be seen. To read the rest, head on over to Minyanville.