When future financial historians look back at the early 21st century, they may wonder why anybody ever thought it was a good idea to repackage subprime securities into triple A bonds. So, too, in relation to assumptions about the “risk-free” status of western sovereign debt.
After all, during most of the past few decades, it has been taken as a key axiom of investing that most western sovereign debt was in effect risk-free, and thus expected to trade at relatively undifferentiated tight spreads. Now, of course, that assumption is being exposed as a fallacy. Just look at those Greek haircuts, or the scale of future losses now being implied in the credit derivatives markets for Portugal, Ireland and Italy.
As the turmoil in the eurozone spreads, forcing a paradigm shift for investors, the intriguing question now is whether we are on the verge of a paradigm shift in the regulatory and central bank world, too. After all, it is not just investors who have tended to assume that mainstream sovereign bonds are risk-free; this assumption has also acted as a pillar of the entire regulatory structure, and many central bank operations.