This from Sovereign Society:

The odds are growing that one or more sovereign borrowers in East and Central Europe will default in 2009 unless the financial hemorrhaging stops. Local banks in these markets have been battered, currencies have declined sharply, liquidity is running dry and stock markets have collapsed.

With global markets once again reeling from the next chapter of disastrous bank-related earnings and the prospects of full government nationalization on the horizon in several countries, another blow to investor confidence might be around the corner: a sovereign government default.

According to the Financial Times, global bond issuance in 2009 will reach an all-time high of more than US$3 trillion dollars – three times greater than last year. In the United States, the Treasury will auction almost US$2 trillion dollars to fund monster fiscal spending packages and bailouts; in Europe issuance is expected to reach more than US$1 trillion dollars.

Euro-zone Failed Auctions

Several European countries in the euro-zone have struggled to meet bond auctions, including the world’s second-largest fixed-income market – Germany.

Since October, Germany has failed to meet its bond auction targets on four separate occasions, either reducing or scrapping government bond auctions altogether amid poor investor demand.

Investors are growing nervous because of the unprecedented funding requirements for European fiscal spending in 2009 as the financial system yearns for a wave of fresh capital amid bank equity deflation. The United Kingdom has announced the first initiative to collateralize all toxic bank assets with implicit state guarantees – a first at this stage of the credit crisis.

Elsewhere in Europe, countries like Austria, Spain, Belgium, Italy, Holland and Ireland are struggling as interest rate spreads versus German bonds continue to soar. Rising spreads mean investors are growing more risk-averse and demand higher interest rate compensation compared to Germany – the regional safe-haven market.

The euro-zone is now awash in bond supply as countries race to sell debt to finance fiscal spending packages and increasingly, bank bailouts that will probably result in government nationalization of the battered financial services sector.

HSBC Credit Swaps Cheaper than Most European Governments

The cost of credit protection measured vis-à-vis credit default swaps (CDS), which protect lenders from an issuer defaulting, have soared over the last several weeks for the United Kingdom, Italy, Spain, Greece and Ireland among others.

It now costs more to protect against a default in several European nations than it does to insure against HSBC – the world’s biggest bank. That’s a major 360-degree shift in investor sentiment because 12 months ago, the tables were turned in favour of sovereign governments.

Earlier in January, the rating agencies downgraded Greek and Spanish debt and other countries, including Italy, Belgium, Ireland and the United Kingdom might be next. A credit downgrade implies rising funding costs for government borrowers as the market places a higher interest rate premium on sovereign debt.

While funding gaps lurk for countries sporting bloated debt-to-GDP ratios, others in the emerging markets are in worse fiscal shape with the IMF already bailing-out three countries over the last six months.

Debt-to-GDP Ratios Surge in Eastern Europe

While the financial panic gripping the industrialized nations has been frightening, particularly for Western governments, the scope of the disaster is now beginning to threaten the ability of some countries to service their debt burdens in the emerging markets. That’s because many countries in East and Central Europe have amassed a mountain of short-term debt obligations, threatening debt servicing as local currencies plunge.

In many ways, the current funding crisis among weaker emerging European borrowers is similar to what occurred during the Asian economic crisis starting in 1997. Most nations in the region also accumulated massive short-term debts denominated in dollars.

Many currencies in the emerging markets have crashed since last July, raising their cumulative debt-servicing costs and limiting their ability to raise fresh capital from global investors. This is especially the case in the Baltics and the Balkans.

In 2008, Ecuador and the Seychelles defaulted on their debt.

Since last fall the IMF or International Monetary Fund has bailed-out Iceland, Hungary and Ukraine. More countries might be next in the emerging markets and quite possibly, even in the euro-zone.

According to Deutsche Bank, combined current account deficits and debt of Eastern and Central European countries is around 18% of GDP or gross domestic product compared with only 8% in Asia and Latin America. Some countries are now in the danger-zone with explosively high debt ratios, including Estonia, Latvia and Lithuania.

Credit Spreads Point to Danger, Possibly Default

In the euro-zone, Ireland, Greece, Portugal and Spain maintain the highest credit spreads over German bonds in late January ranging from 3.39% for Greece to 1.73% for Spain.
Indeed, investors have demanded higher interest rates to compensate them for rapidly rising deficits in these and other euro-zone countries.

Yet the credit spreads in Europe are kids’ stuff compared to recent developments in the emerging markets.

Ukraine, which has already received IMF aid, must rollover approximately US$30 billion dollars of funding this year while Hungary requires US$15 billion dollars. The spreads on Ukrainian dollar-denominated debt compared to benchmark U.S. Treasury bonds is now 24.4% – only second to Ecuador’s 32.7%, which has technically defaulted in 2008. Other countries with soaring borrowing premiums include Argentina and Venezuela.

Avoid Emerging Market Debt

Not all emerging market sovereign borrowers are threatened by default. Some countries, like Brazil, probably hold better risk-adjusted returns than most industrialized countries over the next 12 months. Brazilian credit spreads have risen as well since last year but remain at a respectable 3.31% above Treasury bonds and are still rated investment-grade.
Yet for most emerging market bond issuers, the cost of raising capital is certainly on an uptrend in an environment of shrinking trade surpluses, rising deficits and a full-fledged recession in key export markets.

Investors should avoid emerging market debt as risk of default spreads and raises funding costs for even some of the safest credits. Spill-over is already breaching the haul of several leading issuers.

The J.P. Morgan Emerging Markets Bond Index now yields 9.42% or 682 basis points (6.82%) more than Treasury bonds. That yield spread peaked last October at 12.21% at the height of the panic. Yet it would seem plausible that spreads will rise again as one or more sovereign borrowers in this asset class default. Many of the highest indebted borrowers, including Ukraine, have amassed huge amounts of short-term debt that must be refinanced.

The best time to buy emerging markets is amid a full-blown panic. Though we’re not at the point of maximum pessimism yet, investors will eventually feast on double-digit yield spreads as defaults increase in 2009.

Combined with crashing or weak currencies, this is not the time to be a hero in emerging market debt as default risk heightens.

Source: The Next Shoe to Drop Might be a Sovereign Borrower

Investors will be utterly confused today about what to fear most. First, you had the nightmare open in New York on Friday. The futures markets were limit down and closed briefly. By the time order was restored to electronic markets, the Dow opened down 6%.

The Dow rallied-if you can call it that-to close down “just” 3.6% on the day. A that point, you could safely say the market was ‘pricing in’ the fear of a global recession, and just what that would mean for corporate earnings. Not even an oil price of US$65-meaning lower prices at the pump-could cheer investors.

And then, this weekend, European and Asian leaders met and, “pledged to undertake effective and comprehensive reform of the international monetary and financial systems,” according to Bloomberg. China’s Premier summed up the argument for the 40 heads of state present by saying, “we need even more financial regulation to ensure financial safety.”

And thus a great debate unfolds in the weeks ahead of the November 15th G20 summit in Washington. Was the crisis a result of unregulated “cowboy capitalism”? Or did it have its roots in phony, government-regulated interest rates, which skewed corporate and personal incentives in favour of debt-based speculation? More that in a moment.

Did you see news reports that the RBA intervened in the currency markets? The Bank is trying to prevent the Aussie dollar from going “splat!” Truly, there are few currencies in the world that have fallen so much, so quickly. But why?

Chatting with Swarm Trader Gabriel Andre this morning, he said the seven-year up-trend in the Aussie-Yen currency pair has been completely reversed in the last three months. Kris Sayce will be running Gabriel’s comments in today’s Money Morning. What does it mean?

The currency pair is as good a symbol as any for what fuelled the global rise in speculation. You could borrow virtually for free in yen and invest in high-yielding currencies and assets. Those assets included Aussie stocks and the Aussie currency itself. The collapse of the yen and dollar carry trades is what’s behind the plummeting Aussie dollar.

Meanwhile, the government still hasn’t fixed the problem that’s mushrooming in the cash and mortgage fund market. Over $11 billion is still frozen in those accounts as the firms that run them try to work out a deal with the government. But what deal could there really be?

Investments in mortgage funds are not deposits in banks. By guaranteeing bank deposits, the government drew attention to the fact that investments always have risks, and that some risks cannot be insured against. You either take them and accept the risk (in exchange for the return), or you keep your cash in a safer, but lower-yielding security (or in cash, subject to inflation).

It would be nice if you could get a guarantee in life that you’d never lose money no matter what kind of decision you made. But no such guarantee exists. It just happens that we live in an age where no one expects to lose at anything, ever. This goes for kid’s soccer games as well as financial markets. But if there aren’t real winners and losers, you don’t have a real market.

Congratulations to our friends at www.businessspectator.com.au. The financial news and analysis site is turning one year old this week. It’s a precocious one-year old, though. And there is a lot of collected wisdom there.

For instance, Robert Gottliebsen recently made this chilling observation about the hedge fund meltdown, “The mortgage fund freeze has escalated the number of superannuation investors who are demanding to exit the managed fund equity system. At the moment it is containable but if the move to quit shares balloons we will see big forced selling of Australian stocks.”

Hopefully the mortgage freeze will end soon. Perpetual says this morning that it would like to end its freeze on redemptions as soon as possible. Exactly when that is is anybody’s guess.

As if the credit crunch and a global recession weren’t bad enough, investor now have to deal with calls by the Europeans and Asians for Bretton Woods two. Everyone wants a new global financial system. But it’s not like buying a new shower head or toilet seat, is it? You can’t just run down to the shops and get one, along with some beef jerky.

It’s obvious the current system is breaking down. Globalisation-made possible by cheap money and cheap energy-is contracting. You know for certain that governments, being blame artists, will blame markets. But it’s not the market’s fault. As with every bubble, from Tulips to the South Seas to the Mississippi Scheme, it’s people who pervert markets.

Sure, CEOs and corporations turned normal businesses into vehicles for private speculation. But that is a failure of management, not the market. More oversight by corporate boards and shareholders might have made for better discipline in risk taking. But discipline is exactly what people lose in a bubble.

The credit bubble was remarkable because it leveraged the interconnectedness of global markets, allowing investors to borrow in weak currencies and invest in high-risk, high-yield assets. It wasn’t a regional or even national bubble. It was the whole planet.

But in its other essential features, it is indistinguishable from previous bubbles, manias, panics, and crashes. One of those features in fact, is how governments and bad regulations actually enlarge, prolong, and generally abet the bubble. And in this one, because everyone had a stake in its expansion, everyone has tried to keep it going. The best example of this is the determined allegiance to the dollar-pegged world financial system.

The price of money is fixed by central banks via interest rates. For years, everyone followed the Fed’s lead in the U.S. and set the price of money below rate of consumer price inflation. Australian mined. China produced. Europe traded. OPEC pumped. The U.S. spent.

Global bubbles in all asset classes ensued. That is a failure of the highest order by the regulators of global interest rates. Now politicians see massive wealth destruction and blame free markets for screwing things up when it was the non-market price of money that touched off the crisis to begin with.

In any event, we’re going to get some sort of hogwash in the next month from the confab in DC. There will be more supervision of banks. It will probably lead to less bank lending and tighter credit. Hedge funds will be regulated. Many investors will anticipate this by taking their money out ahead of time. Redemptions will force more asset sales. Stocks will fall.

The International Monetary Fund will probably enjoy some enhanced status. The IMF is already bailing out a bankrupt Iceland. It will loan US$16.5 billion to Ukraine. Before it’s all over, we reckon Japan and China might even consent to loaning some of their huge dollar reserves to the IMF in exchange…for something.

We’re not sure what it would be yet. The IMF may become a super-bank with access to funding from central banks, a kind of supra-sovereign wealth fund in the service of a world government and regulation. That sounds…not encouraging.

Also, keep in mind that the entire strain of the crisis in the U.S. was generated by a politically desirable outcome in residential housing. The original mis-allocation of investment dollars came about because politicians insisted that banks make loans to people who couldn’t repay them. Market discipline was actively subverted by political opportunism.

The U.S. set up Fannie Mae (FNM) and Freddie Mac (FRE) with preferential borrowing terms so those two could buy up mortgages originated by the banks. The banks could sell the mortgages quickly, which put them in the position to fund even more mortgages and expand “home ownership” in America.

We all know how that’s working out. Median U.S. house prices continue to fall. The loans made to finance those homes are going bad. The securities made up of bundles of those mortgages are rotting, taking bank capital with them. And insurance sold against default in them is putting the sellers of that insurance into great difficulty.

Europe, for its part, has a brewing problem in emerging market debt. Austrian banks are exposed to sovereign emerging market debt to the tune of 85% of GDP. Swiss banks have emerging market debt equivalent to 50% of GDP. It’s 25% in Sweden, 25% in the U.K., and 23% in Spain. If more emerging markets go the way of Iceland and default on debt or go bankrupt, Europe’s banking system faces major trouble. Just what we needed. More trouble.

Dan Denning
for The Daily Reckoning Australia

Source: Europe Faces Day of Reckoning in Emerging Market Debt