When rescuers need rescuing
If the era of automatic sovereign bailouts is ending, then so too is the idea of "risk-free" bonds -- lifting the anchor of world debt markets in stormy waters.
Even if it's unlikely to be quite so black-and-white, creditors and investors are at least rethinking the long-held view that European states or even global bastions like the United States or Japan will always pay them back at face value.
"There is no such thing as an absolutely safe sovereign," according to Citi's chief economist Willem Buiter.
The intensification of the euro zone debt crisis and Ireland's need for the bloc's second state bailout of the year is making policymakers fret about endlessly underwriting private creditors -- feeding yet more market anxiety.
It's a spiral that some experts say may rebound on European Union leaders, forcing them to formally abandon the bloc's "no-bailout" pledges to stop the crisis destroying the euro.
This week's move by European governments to enshrine the debt restructuring codes in the small print of new bonds after 2013 was intended to dispel any such notion -- leaving it to a creditor majority to thrash it out with any insolvent sovereign.
Not untypically, the euro proposal leaves acres of grey area. Who decides when a state is insolvent and how? How is insolvency distinguished from temporary "liquidity" shocks, which still allow for bailouts? And, in the event of a restructuring haircut, who guarantees the remaining principal?
But in opening up the possibility that default may be acceptable, the inclusion of Collective Action Clauses in euro sovereign debt undermines the running assumption of many the creditors to what are deemed Advanced Economies.
Since World War Two, sovereign default has mostly been a matter for emerging markets or developing countries. Periodic International Monetary Fund bailouts, bankrolled largely by the United States or the rich Group of Seven nations, typically prevented payments problems even getting to that point.
The last of the existing "advanced economies" to default, according to Citi, was West Germany in 1948.
But the potential for sovereign insolvency is no longer the preserve of the developing world. If anything there's been a role reversal.
"Who rescues the rescuers? There's no obvious answer to that," said Joachim Fels, co-head of global economics at Morgan Stanley, adding the euro debt crisis would now likely to spread to "core" European countries.
IMF papers that viewed advanced country defaults as unnecessary and unlikely represented "a triumph of dogma over evidence and logic", Buiter said, adding sovereign insolvency was rife, especially when guaranteed bank debts or long-term pension and healthcare liabilities are taken into account.
"Despite the recent drama, we believe we have only seen the opening act," Buiter told clients this week.
"The risk of sovereign default is manifest today in Western Europe, especially in the euro area periphery. We expect these concerns to extend soon beyond the euro area to encompass Japan and the United States," he said.
If markets question the sustainability of G7 government debt at a time when many see a significant bubble in these assets, the effect could be seismic.
Repricing and re-rating G7 government debt and the possible re-ordering of these securities in bank, pension fund and insurer portfolios everywhere could be traumatic because it forms the benchmark for all corporate and state borrowing and is a cornerstone of investment strategies seeking relative value.
Default risk -- as opposed to simple "term risk" -- has yet to be priced adequately in benchmark sovereign yield curves. Basel bank capital rules, meantime, still assign "zero risk" weightings to sovereign debt holdings.
Studies on the increased use of collective action clauses in emerging sovereigns over the past 10-15 years show little impact on borrowing rates. Their existence may even act to lower funding costs in some cases.
But this was at least partly due to the fact that in the risky area of emerging markets, CACs provided a orderly and agreed outcome in place of messy default or unilateral haircuts.
The problem for the euro zone or wider G7 Treasuries is that few if any of their investors even entertained the prospect of default in these countries, messy or otherwise.
Perhaps it's understandable then that those seeking a turning point in the euro zone contagion reckon one of the few incentives to buy would be on Europe abandoning its "no bailout" clause in Article 125 of the European Union's Lisbon Treaty.
"The crisis will force the EU to move toward a permanent solution by beginning negotiations to amend the "no bailout" clause ... and establish a system of cross-guarantees for sovereign debt," UBS told clients.
"Investors should then be able to ride what we regard as the "end" phase of the sovereign debt crisis: a multi-year convergence of European sovereign spreads."