Insanity -- Part Deux

Simon Johnson, ex of the World Bank and someone who perhaps more than anyone else saw the role of the banks in precipitating the 2008 financial crisis, writing today in the Financial Times

As this pressure mounts, we’ll see cracks appear also in the private sector. Significant banks and large hedge funds have been selling insurance against default by European sovereigns. As countries lose creditworthiness – and, under sufficient pressure, very few government credit ratings will hold up – these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).

Remember that none of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008. And generalized counter-party risk – the fear that your insurer will fail and this will bring down all connected banks – raises its ugly head again.

In such a situation, investors scramble for the safest assets available – “cash”, which actually (and ironically, given our budget woes) means short-term US government securities. It’s not that the US is in good shape or even has anything approaching a credible medium-term fiscal framework, it’s just that everyone else is in much worse shape.

Another Lehman/AIG-type situation lurks somewhere on the European continent, and again our purported G7 (or even G20) leaders are slow to see the risk. And this time, given that they already used almost all their fiscal bullets, it will be considerably more difficult for governments to respond effectively when they do wake up.

With markets down sharply over the past month or so, it might be time to stay on the sidelines for a while yet.

Oh . . .

And remember that government debt that a robust recovery was going to torpedo the price of? Its looking better every day.