Other People’s Debt

Filed Under (The HELL You Say!) by admin on 23-02-2010

We do not need one more issue to put on the risk meter, but we have one now, Greece.  As if our debt in the US is not a big enough problem, we now have to contend with other people’s debt.  Welcome to the beginnings of the Sovereign Debt Crisis!

Yes, this is a real problem.  If Greece defaults on its debt, this will be the biggest sovereign default in history.  If they are bailed-out, it will be the biggest sovereign bail-out in history. Greece’s debt is about 113% of their Gross Domestic Product.  Incidentally, our debt is almost 87% of our Gross Domestic Product.  Euro-zone countries Portugal, Italy, Ireland, Spain, and mainly Greece, all appear to be in over their heads with exploding deficits.

What is sovereign debt?

Sovereign debt is created by the issuance of bonds by a country’s government. During the meltdown, countries all over the world issued debt in order to fund their stimulus programs. Now, that debt in addition to the debt they already had, is morphing into a problem that affects everyone.

This potential debt crisis Round Two could play out much like Round One did as corporation after corporation had to be bailed out. The difference between now and then has to do with the lender of last resort. The lender of last resort is the government or entity that steps in and bails out the country or the corporation that is on the verge of collapse. The problem is that we are all bailed out. This is evidenced in the fact that the EU is slow to respond to Greece’s credit crisis.

Think of it like this – In financial crisis Round One, it began with Bear Sterns needing to be bailed out. Corporation after corporation had to be bailed out and then Lehman was allowed to fail, causing a huge meltdown in the credit markets. There are more countries than Greece that are in trouble in the EU. If Greece falters on the payment of their debt, then lending would virtually dry up to the other weak European countries.  This would result in a contagion of trouble, first Greece, then Portugal, then Spain, etc. Unfortunately, the probability of that happening is higher than most on Wall Street want to admit.

The Dark Side of a Bail-out

The EU is hesitant to step in and bail-out Greece.  This amount of debt causes their interest rates to rise.  Interest rates have been rising and are getting dangerously close to a point where Greece will be forced into default.

Greece is begging for a bail-out.  The EU tells Greece, not so fast, if you want help with your debt in the form of a guarantee by the EU, then some tough choices are going to need to be made.  Greece will actually be forced to cut spending and oh no…make wise financial decisions.  This is something foreign to the US Government. For the past few years, we have been modeling financial irresponsibility for the rest of the world.  The EU has been watching and has come to the conclusion that bailing out a country without conditions might not be too smart.

It would be just like your child coming to you with $20,000 dollars in debt requesting a bail-out.  You help your child while allowing them to keep their credit card open. It is also like bailing out companies in the US without any restrictions.  It is not too smart.

The day of the US style easy money bail-outs are over.  Now, bail-outs come with tough terms and conditions.  Shouldn’t it be that way?  Would the US be in a much better place if our creditors would have told us that the US can borrow money as long as changes were made?  The problem is that we are borrowing the majority of our money from ourselves.  So, that means we would be forced to actually be wise and make prudent fiscally responsible decisions on our own.  As long as there are politicians in Washington, that will not happen.

John Mauldin points out that there is no good solution for Greece.  The terms and conditions of a bail-out are going to be as tough as the cons of defaulting on debt.

While German Chancellor Merkel has indicated a willingness to help, the German finance minister and other politicians are suggesting German cooperation will either not be forthcoming or only be there at a very high price; and the price is a severe round of “austerity measures,” otherwise known as budget cuts. Greece is being told that it must cut its budget to an 8.7% deficit this year and down to 3% within three years.

Now, here is where it actually gets worse. If Greece bites the bullet and makes the budget cuts, that means that nominal GDP will decline by (at least) 4-5% over the next 3 years. And tax revenues will also decline, even with tax increases, meaning that it will take even further cuts, over and above the ones contemplated to get to that magic 3% fiscal deficit to GDP that is required by the Maastricht Treaty. Anyone care to vote for depression?

And add into the equation that borrowing another E100 billion (at a minimum) over the next few years, while in the midst of that recession, will only add to the already huge debt and interest costs. It all amounts to what my friend Marshall Auerback calls a “national suicide pact.”

  • from John Mauldin’s Frontlinthoughts.com

What ever happened with the other potential sovereign debt crisis in Dubai?

Remember back in December when Dubai was on the verge of default?  They were given a little time to work it out.  Aapparently, Dubai has not done anything to solve this problem.  CNBC reported this week that “Dubai World will offer creditors either 60 percent repayment over seven years and a government guarantee, or full repayment with a debt for equity swap for property assets of Nakheel and no guarantee.”

Those aren’t good solutions.  The issues that we still deal with in an ongoing financial problem in our own country are seemingly contained for the time being in the fact that everyone is getting used to the new normal.  However, the sovereign debt (debt from other countries) crisis is an entirely different deal and new dynamic for the markets.


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