Posts Tagged ‘contingent liability’

Australian government’s contingent liability to exceed AU$1 trillion

Sunday, March 29th, 2009

In October last year, the Australian government splashed its AAA rating to bank deposits (including the deposits of credit unions and building societies) and wholesale bank debt. Last week, there’s news that they’re splashing their AAA rating to state government’s debt.

This is akin to parents giving their children supplementary credit cards unsupervised. Indeed, a particular child named “Macquarie Bank” used the Australian government’s ‘supplementary credit card’ on a debt-gouging spree overseas.

Altogether, the Australian government is projected to have a contingent liability of more than AU$1 trillion, which is almost the entire GDP of Australia (compare that to the last budget surplus of around a puny $20 billion). The nature of contingent liability is that it is not really a liability- it is a liability that arises if certain events arises. This may not be a problem if debt defaults follow a nice Bell curve. But in the real world, is this a realistic assumption? As we said before in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

Bell curve simply means that things revert to the mean in the long run. Also, as you deviate further and further away from the mean, the probability of that deviation will drop faster and faster. Therefore, by the definition of the Bell curve, extreme deviation from the mean is extremely unlikely, so much so that it is close to impossible.

Very unfortunately, it is obvious even from just a casual observation of the world around you, the universe is often not ruled by the Bell curve. Extreme events occur frequently, which by definition of the Bell curve is close to impossibility.

Our feeling is that a huge unquantifiable percentage of all these debts will have a high degree of correlation with each other. Another way to look at this is that what makes a particular debt go bad is what makes the others to go bad as well. This means these debts will not follow a Bell curve. If you look at Australia’s money supply graph in Australian money supply growth in September 2008, you can appreciate the level of leverage in Australia’s financial system. What if Australia faces a huge macroeconomic margin call? Should that happen, there goes the Bell curve.

We shudder to think how the Australian government’s sovereign debt rating will fare when the day of testing comes. With so much contingent liability on their shoulders, we believe the Australian government is setting itself up to be run over by a Black Swan. For those who are new to Black Swans, we recommend Failure to understand Black Swan leads to fallacious thinking.