The Giant Quality Swap

Global Investment Strategy Weekly (05/13/2010)
"The U.S. has confronted its own debt crisis and Great Recession by swapping private-sector debt for public-sector debt. The financial bailouts and TARP program have dramatically increased public-sector indebtedness, allowing the private sector to default or deleverage. The Federal Reserve's MBS purchases have not only lowered the quality of its balance sheet but also opened up the way to quantitatively easing monetary policy.

In a similar vein, the European rescue package is a gigantic quality swap: The healthier parts of the EU are being forced to take on more debt in order to help the troubled economies in the South. The net result will be bigger budgetary deficits in Germany, France and other participating countries, which will be financed by issuing more bonds.

At this point, the long-term ramifications of this 'quality swap' remain unclear, because it is hard to determine how much of the assembled funds will actually be used. As well, whether there will be any funding pressures in the core European bond market also depends on the supply of—and demand for—global savings. Regardless, what is certain is that the public finances of the healthy parts of Europe will deteriorate going forward."

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