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Peter Morgan

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Bad Traders Are as Responsible as Governments for the Current Sovereign Debt Mess

Posted: 24/06/2012 23:06

The emphasis of the blame for the current financial situation across the eurozone has been put on governments for issuing large amounts of debt, which have become excessive to the point of collapse. However I am not so sure they are solely to blame. There are two sides to a debt contract, one is the issuer and the other is the purchaser. One is not possible without the other. For a government to get into such large amounts of debt not only does the government have to be willing to sell bonds but someone else has to be willing to purchase them.

When you go to a bank and invest money they invest that money elsewhere. Your money will be bundled up with other savers money and used to purchase a myriad of products available in the financial market. The bank serves you and acts as an agent investing in a portfolio of products on your behalf, with the intention of providing the best return at the lowest rate of risk. A successful bank will do two things. The first is investing the funds they have in the best financial products that provide a strong return and security creating a valuable portfolio. The second is managing the size of the reserves they hold to cover the withdrawals of customers who wish to take money out of their account.

If too many people take money out of their bank account at one time the reserve may not be large enough to cover the withdrawals. This will result in bank failure if the bank cannot secure funds elsewhere to cover the size of the withdrawals. This was seen recently in the UK when Northern Rock received a bailout to prevent a bank run. The reserve management failure and the subsequent government bailouts have been the major recipients of the criticism of the problems within the banking system. However the successful investment in a secure portfolio, or lack thereof, has in my opinion been the real failing of the banks and has not received anywhere near the amount of criticism it should have.

The situation in the eurozone is an example of this. The governments who issued the excessive sovereign debt have been criticised and punished through austerity. However the banks and the traders who acted on their investors behalf have not been criticised in the same way. If the traders were researching the products they were investing in properly then they would have appreciated the extent of the sovereign debt in the failing PIIGS member states of the eurozone. The member states of the eurozone have to comply within regulations on sovereign debt levels and how they are reported. These regulations were not met by the eurozone PIIGS member states for various reasons, which you can read about in my book here.

Regardless of the inability of the eurozone member states to report the extent of the debt they issued. I believe the sovereign debt crisis could have been and should have been avoided through the analysis the bond traders were expected to have done before they invested money in these products. As there are two sides to the debt contract I find it hard to believe that trading institutions, such as the Bank of International Settlements (BIS) and the exchanges themselves did not know the volume of trades which were taking place in sovereign debt products.

The paper trail could be traced through the purchasing volumes of these debt products rather than through the selling of the products performed by the member states National Statistical Institutions (NSI's). Perhaps it is time the exchanges reported the number of sovereign debt transactions that are taking place. This could become the method for reporting outstanding debt obligations on a national level in the future. Regardless of the issue of clarity in the reported figures it seems odd to me that so many traders have invested in sovereign debt products.

I think it is a case of 'Moral Hazard', where the trader has not acted in the best interest of the investors they are acting on behalf of. It seems sloppy to me that due care and diligence was not taken before these products were purchased. Sovereign debt until recently was considered the risk free secure option for portfolio investment. Traders should not be investing such high proportions of their portfolios in low profit yielding investments. They should be investing in a diverse portfolio of products, which reduces risk and compensates for the low return of the more secure products through the high return of the riskier products. So why have traders been so inclined to invest in low yielding investments?

Not only do I think that this has created an opportunity for weaker sovereign powers to get into debt, I think it has come at the cost of good investments in the free market being overlooked. Preventing the funds from getting to where they are needed in new businesses and product development. So why have the traders done this? I think they have become so used to taking a salary for managing other people's money and receiving praise for the social standing they have attained through their earnings that they have become complacent. The social grandeur of their position has led them to believe they can behave in any fashion they like.

The money they manage is after all not theirs so they have not real interest in maximising the returns. It takes effort to seek out the best financial products and it is much easier to put the money away in so called, 'risk free rate' investments available in sovereign debt products. Regardless of the reason behind the failure the question that remains is why have the traders not been reprimanded or better yet sacked? You hear the occasional segment on the news about a trader who lost billions and faces legal action or the odd investment fund goes down but not much more than that.

My criticism is stronger than that. I want to know why traders have not been in trouble for the poor investment decisions they have been making regardless of the size of the loss. A portfolio that is not diverse is susceptible to high risk and is in my opinion a moral hazard. So why have they been able to keep their positions if they are not acting in the best interests of their investors and providing such a poor service? It is something to think about next time your pension fund takes a battering on the markets.

 
 
 
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