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Monday, July 25, 2011

Washington fiddles around while global markets are set to burn

July 25, 2011WASHINGTON –  Not for the first time, asset managers may be playing a high-risk game as they face the threat of a U.S. debt default without concrete contingency plans. It highlights the investment community’s reluctance actively to seek insurance for a low probability or “tail risk” event, even after suffering huge losses following the collapse of Lehman Brothers in 2008. This was the tail risk that materialized. At the same time, those investors who have hedged may end up suffering bigger losses in the event that U.S. lawmakers do reach a deal because the risk of default is political, not a case of real solvency. The clock is ticking toward an August 2 deadline to avoid a default, with politicians deeply divided over a broad deficit reduction deal that would clear the way for Congress to raise the $14.3 trillion debt ceiling. The risk of a U.S. default — that would, to say the least, trigger a sell-off among pension and money market funds which must hold triple-A assets and push up long-term rates — is getting bigger day by day. Yet mainstream investors appear to be insufficiently prepared for the worst. Illustrating their relaxed stance, fund managers polled by Bank of America this month did not even list the U.S. default risk as one of their top 5 biggest tail risks. The yield on one-year U.S. Treasuries stands at just 0.17 percent, near all-time lows, supporting the view that investors are not panicking. “The main scenario of most investors is they will reach an agreement, I don’t think investors are prepared. It’s hard to prepare for such a tail risk,” said Alessandro Bee, fixed income strategist at Sarasin. “It’s like preparing for a nuclear fallout. Risk cannot be insured. Normal risk can be insured but insuring this sort of tail risk is something that is not possible. ”According to Sarasin, households, pension funds and money market funds held a combined $1.8 trillion of U.S. government bonds, out of $9.6 trillion outstanding. The bigger holders are foreign central banks — mainly China and Japan — which hold a total of $3.3 trillion. Here, the decision is a political one. Xia Bin, academic adviser to the People’s Bank of China, said China should not worry about stalled U.S. debt talks, predicting that politicians will ultimately reach a deal. Japanese Finance Minister Yoshihiko Noda, when asked about the breakdown in the U.S. debt talks, only said that he would be watching the situation. Given the lack of alternatives and the depth of the market, investors have been sticking to U.S. Treasuries for the time being. Triple-A euro zone government bonds, by contrast, have debt outstanding of just $4.3 trillion. -Reuters

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