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Addicted to love (of guarantees)

August 3, 2009

Going through a very dense (77 pages) Bank for International Settlements report on financial sector rescue programs, I found some nice nuggets on bank debt guarantees.

First, the authors found that the biggest investors in debt guaranteed by governments included in the study are banks – meaning that all that talk about jump-starting lending to consumers and businesses was largely just that, talk.

…the dominant role of banks among investors implies that these bonds de facto subtract resources from the interbank market and do not stimulate bank lending to the real economy, but just lending to other banks.

And second, since this debt is backed by sovereign nations, there’s essentially no credit risk associated with the debt. That kind of safety can lull investors into a habit-forming addiction that could be ugly when the supply runs dry.

In the medium term, after guarantees are removed, it may not be easy to revert to normal conditions, where investors monitor banks and price bonds according to the characteristics of the issuer. In other words, unless banks return quickly to soundness, convincing the “credit risk seeker” investor base to resume investing in unsecured debt may turn out to be an expensive task, with potential adverse consequences for the real economy.

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