Overview Of The Sovereign Debt Crisis

With the term “sovereign debt crisis” we refer to a period in which several countries experienced the collapse of financial institutions, banking failures, volatility of aggregate economic activity, high government debt and rapidly increasing bond yield spreads in government securities. Recently, this kind of crisis has affected many European countries. It was a European sovereign debt crisis which began at 2008 and hit some countries particularly hard. Actually, when we talk about sovereign debt problems we mean that a country is unable to pay its bills. But it is not that simple and does not happen overnight. There are plenty of warning signs before the “big bang”. The aim of this paper is to examine briefly the causes behind the spread of the sovereign debt problems and to make a special reference to the role of securities to the whole crisis.

The roots of the sovereign debt crisis

To understand the causes of the sovereign debt crisis it is necessary to start with some events that have triggered chain reactions to many sectors of financial services. Unlike the banking panics of the 19th and 20th centuries the 2008 banking crisis has commented by economists and analysts as some kind of ‘wholesale panic’ instead of ‘retail panic’. The past years, when depositors need cash the just went to the banks and demanded cash in exchange for the checking accounts they held. But the 2008 bank panic involved mainly firms and/or financial institutions ‘running’ from one to another by not renewing sale and repurchase agreements (known as ‘repo’) or increasing the repo margin (known as ‘haircut’). This has in turn caused massive deleveraging.

In fact the 2008 bank panic centered on the repo market, which has ‘rocked’ when depositors demanded increasing haircuts due to concerns about the liquidity and the value of the collateral. Some of the firms/institutions, under the pressure and lack of transparency, start ‘withdrawing’ their deposits from other financial firms and institutions through ‘repo haircuts’.

Another factor that should be mentioned since it has a crucial role to the begging of the crisis is the U.S. subprime mortgages. After the 2001 facts (terrorist attack) and the resulting insecurity and instability that it has caused in all areas of economic and social life there was an attempt from the U.S. government to stimulate the economy. One way to achieve this was through the promotion of housing investment Subprime mortgages was a financial innovation specially designed to provide home ownership to people with poor credit history (high risk borrowers). The whole operation has been designed so that each mortgage has a particular design feature that resulted in linking the outcome to house appreciation. U.S. subprime lending and borrowing market promoted law interest rate incentives to riskier borrowers. This has arisen from the massive belief that property prices will continue to rise. According to this belief the so called “bad loans” could not be a problem as the property (house) could easily be resold for a profit.

Subprime mortgages were financed via the process of securitization, which on turn has a unique design reflecting to subprime mortgage design. However, as the housing prices did not rise as expected this ‘building’ began to collapse.

Metamorphosis of financial system and securitization

Securitization was not a brand new financial technique. It had its roots back to 1980s. It actually loaded by industry commentators as a try to reduce banking system risks and, also, as a means to cut the total costs of credit intermediation. In such a way there would be achieved a reduce of the need of bank capital, which most of the times was unnecessary and expensive. But how exactly could securitization be defined? It is not so easy to describe it. Actually, the term is still little vague. There are both legal and non-legal definitions. According to U.S. banking regulators securitization means “the pooling and repackaging by a special purpose entity of assets or other credit exposures that can be sold to investors’. This definition has been strongly criticized since the term ‘assets’ could mean much more than payment rights. There are, also, many non-legal definitions developed by economists and/or academics, but they have also been criticized as incomplete or inaccurate. But, since securitization has played a major role to both European and global sovereign debt problems we should focus not just to its definition but to the whole mechanism. Summarizing the plurality of texts written by academics, scholars and economic analysts we should describe securitization as a part of structured finance. It is a financing technique by which homogeneous income-generating assets, which on their own may be difficult to trade, are pooled and sold to a specially created third party, which uses them as collateral to issue securities and sell them in financial markets. The securitization transaction starts when the originator identifies a pool of homogeneous assets that satisfy certain features which make them available for securitization. After this first step, the abovementioned pool of assets is transferred to a Special Purpose Vehicle (SPV) at par value. The SPV firstly engaging in ‘tranching’ and after that issues (privately or publicly) securities usually bands, notes or even equity securities which are structured into different classes with different payment priorities and different risk characteristics. These securities are then sold to investors such as banks, financial institutions, insurance companies, portofolio managers and pension plans. Through the issuance of these securities the SPV earns the fund that are necessary to purchase the receivables from the originator. As it is obvious from the aforementioned a securitization transaction is a complex process which involves many parties. So it creates a chain through which a securitized debt product eventually leads to investment returns.

Securitization and other causes of sovereign debt problems

Taking into consideration the words of Adam Smith (The wealth of Nations), famous economist and moral philosopher of 18th century, we can say that economists view the world as being the outcome of the “Invisible Hand”. With this term we could say that, there is a world where private decisions are (unknowingly) guided by prices to allocate recourses efficiently. In this context, it is easy to understand why most people did not think of banking panics and sovereign debt problems as something possible to happen. However, the recent events have led to the change of this view. As mentioned above the transformation of the banking system and the globalization of total economic activities in the last 25 to 30 years have created the conditions for the ‘big bang’.

Securitization’s importance for the development of the economy was undeniable. Through securitization it became much easier to fund small and medium size businesses, as well as infrastructure. Apart from this, securitization gave a way to non-bank finance institutions to fund borrowers who were in need.

The prevalence of securitization in trade, has as a result the movement of massive amounts of loans (in the form of securities), originated by the banks into the capital markets. In turn, this created an enormous demand for collateral. This was one of the factors that triggered the beginning of the crisis.

Therefore, we should keep in mind that this is not entirely random that the researchers and observers strongly support the opinion that securitization contributed to a significant degree to sovereign debt problems. As Henry Paulson-the former treasury secretary and chairman of investment bank Goldman Sachs- highlighted securitization contributed to the overleveraging that has a result the debt problems because it “separated originators from the risk of the products they originated”.

However, securitization should not be considered the one and sole actor of the problem. We should not forget that it is just a tool like many others in the capital markets and it can be used for many, different aims.

There were also many other causes that contribute to sovereign debt problems. The main ones, as recorded by economists, analysts and journalists were: the real estate market crisis and property bubbles in many countries. But one of the key factors contributing to the deterioration of the already negative situation was the peripheral states’ fiscal policies regarding government expenses and revenues. This was obvious to countries such as Ireland, Portugal, Italy and, of course, Greece. The problems of the European periphery should have been identified long time ago, since the root of the problem was not just the lost of competitiveness but mostly, structural characteristics and deficiencies, which in combination with law interest rates, gave rise to excessive private credit growth. The problems accumulated over years and years and then the “boom” happened. Just like that a bank crisis turn out to be a sovereign debt crisis.