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Mark's Market Blog

5-1-10: Sovereign Defaults on the Horizon

By Mark Lawrence

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This week the markets dropped then rebounded from the news that Greece was bankrupt, Portugal is heading at high speed towards trouble, and Spain is only a little behind those two. On Tuesday the market punched a hole through the 20 day moving average floor. On Wednesday the market rebounded, but the old floor had become a ceiling. On Thursday the market punched back through to make the 20 day moving average a floor again. Europe was all excited because even through Greece is heading inexorably towards default, it looks like the IMF (read: US) will bail them out. The US is excited because this is Europe's problem and doesn't involve us. On Friday the market fell through the 20 day average again, on news that Justice was starting a criminal investigation of Goldman and fears that the Greek deal would fall apart. I think this bull market is now chasing little red capes - ignore those little pin pricks in our sides, we're a bull and those can't hurt us. What's coming next? Lots of news this weekend out of Europe, the Greek bailout deal is in place. Analysts have decided that Goldman was almost certainly obeying the law and the Justice investigation will go nowhere, although there is consensus that if Justice actually charges Goldman, then that will likely be the end of Goldman. I expect the market to go up on Monday. After that, who can say? The 20 day moving average has so many holes in it now that calling it a floor or a ceiling is just a joke.

S&P 500 November 1 2009 to April 30 2010

The Fed met and once again said "rates will remain low for an extended period," meaning they will not raise rates in the next few months. Last week we talked about how inflation numbers are cooked by "rent equivalent ownership costs." Consensus (meaning everyone but the guys on the Fed who actually make the decision) is they won't raise rates until inflation starts getting out of hand or unemployment drops significantly. This week I'll just casually mention than anyone who thinks there's no inflation in the US should go grocery shopping. I don't think there will be a rate increase, but that's because the Fed needs to keep the banks on steroids; the coming collapse of much of Europe will be a test of the banks perhaps even stronger than the collapse of Lehman.

On current trends, The General Accounting Office (GAO) says "roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020." Some may recall that there are other departments in the government - defense, energy (what is it that they do?), state, commerce, justice. We've seen in past blogs that the Federal Budget is roughly 5 equal pieces: Social Security and Medicare, Welfare (Health and Human Services), Defense, Treasury (interest on the National Debt), and everything else. Sometime in the next 10 years if the budget is to be balanced, Defense, Welfare and Everything Else will have to go, leaving just interest on the National Debt, Social Security and Medicare. The good news is, a quick scan shows that the Executive and Legislative branches are part of "everything else," so apparently Congress and the President will get laid off. Very appropriate and helpful, if you ask me.

US Federal Budget, breakdown by category

It's difficult to get economic forecasts that don't follow some agenda. Most economic reports come from people with some clear interest - selling stocks, passing desired legislation, generating political trouble for someone. In the US the General Accounting Office (GAO) is about as good as you can do; this is not to say they're perfect, they're just about as non-political as you can find. In the world, the equivalent would likely be the Bank for International Settlements (BIS). They recently put out a paper on the future of public debt. It is generally accepted that when public debt gets too large then governments suck up too much money and economic growth slows or stops. For example, it's currently thought that when debt exceeds 90% of GDP, growth slows by about 1% just because of money going to pay interest on the debt instead of going into business research, development, investment. In the US we need about 4% growth per year for the next decade or so to reclaim the 8 million jobs lost in the last two years. We're not going to get that growth. In the graph below we see interest payments on the national debt projected forwards on current policy. In the US the federal government is about 25% of GDP; by 2040 interest payments on current trends would be about 23%, more or less the entire federal budget.

Interest Payments on Public Debt as a percent of GDP by country, 2010 to 2040

The BIS report included the following graph. For each country we see public debt rising, then three projections. The red projection is if nothing changes: politicians and central bankers keep their foot on the train's gas pedal. The green line is a projection where government spending is cut by 1% of GDP each year from 2012 to 2017. In the US, this is a cut in government spending by about $150B per year, about 4% per year. This means wiping out, for example, all of defense spending between 2012 and 2017. The blue line assumes that in addition, spending on retired people as a percentage of GDP is held at 2007 levels. Since the number of retired people in all these countries is projected to double or triple, this represents cutting social security and medicare benefits in half or worse. In the US, even cutting benefits for retired people in half and wiping out 20% of our budget still leaves our national debt doubling by 2040. This is a train wreck happening before our eyes. Europe and the US under these conditions will have stagnant economies, inflation, no job growth, and declining standards of living for two generations. A US Value Added Tax is coming, it's just a question of when. The future is not in Europe or the US, it's somewhere in Asia if it's anywhere.

Public Debt as a percent of GDP by country, 1980 to 2040

Greek bonds were downgraded this week to junk. The yield on two-year Greek government bonds jumped to 13.5% on Monday, 15% on Tuesday, 17% on Wednesday. Greece's two-year borrowing costs are now higher than those of Argentina at 8.8%, and Venezuela at 11%. Greece's credit rating was lowered deeper in junk status, reflecting the growing conviction that bondholders will lose money. People are starting to realize that there is no way the Greek government can grow their economy to pay off this debt, a partial default is a near certainty. The German government continues to drag their feet on any bailout. There is also growing realization that Greece cannot become a competitive economy at current Euro values, leading some to speculate they will leave the EU and return to the Drachma as their currency. Two-thirds of Greek citizens favor leaving the Euro. Perhaps this is Germany's goal. Normally, a country in Greece's position would devalue their currency, effectively wiping out some of their debt, but Greece cannot devalue the Euro. As the European Union and the IMF debate the politics of Greece’s laying off civil servants or persuading its doctors to pay income tax, it is becoming apparent that the international community may need to come up with a much larger sum to backstop not just Greece, but also Portugal and Spain.

Portugal's stock market was down nearly 5 per cent as Lisbon's long-term credit ratings were also reduced to by two notches from A+ to A-, reflecting the country's weakening public finances. S&P also put Portugal's bonds on "negative outlook watch," meaning they will likely be downgraded in the near future. Spain's rating was cut from AA+ to AA. The UK is likely to be next. A Europe-wide bailout be huge - 90 billion euros for Greece, 40 billion for Portugal and 350 billion for Spain this year alone, and perhaps that much again in next year. The idea that there could be one currency - the Euro - for nearly 30 different economies with 30 different government policies is starting to look, well, quaint.

Bond Ratings

Aa1AA+AA+High grade
A1A+A+Upper medium grade
Baa1BBB+BBB+Lower medium grade
Ba1BB+BB+Non Investment grade
B1B+B+Highly Speculative
Caa1CCC+CCCSubstantial risks
Caa2CCCExtremely speculative
Caa3CCC-In default with little
prospect for recovery

DDDDIn default



In 2008, right after the collapse of Lehman, interbank lending simply stopped: no one knew who might go bankrupt tomorrow morning. It was necessary for the Fed to step in and be the lender of last resort for quite a while. One aspect of this Greek crisis is that in the EU interbank lending is guaranteed by the bank's home government. If Greece defaults and Portugal and Spain look not far behind, banks may wonder if that guarantee means anything. The EU doesn't have one powerful monetary organization like the Fed to step in and keep markets functioning. The Greek situation could lead to a complete breakdown of the European cross-border banking system.

How did this happen? Imagine you're thinking of buying California bonds. You would be worried about California's ability to pay back those bonds, that is default risk, and you would demand higher interest rates to compensate for this risk. Now imagine you're thinking of buying Argentina's bonds. Not only are you worried about default risk, but you are also worried that they will simply print a bunch of money to pay off bonds leading to inflation and a dropping currency - they borrow $100,000 from you, and pay back $50,000 given the drop in value of the currency. This is inflation risk. In the 90s, Greece had both. In the last 200 years, Greece has been in default for nearly half of them, and inflating their currency for most of the rest. Then Greece joined the EU and adopted the Euro. It was thought that the Maastrict treaty would keep Greece from defaulting, and there will be little or no inflation in the Euro as long as there's a Germany. Think of a family making $35,000 per year, and suddenly they get a new credit card in the mail with a $100,000 credit limit and 3% interest rate. They run right out and buy a Lexus, all new furniture, and a vacation in, well, Greece. Then one day someone asks, How will these people ever pay back $100,000 on a $35,000 salary? Just the $3,000 per year in interest is more than they can handle. Dad announces that the family has to cut back on spending, grandpa needs to get a job to help out, and allowances will be cut. The teenagers get very angry and announce no more vacuuming, emptying the dish washer, mowing the lawn until Dad relents and increases allowances.

Greek teenagers Teachers on strike

In the case of Greece, their bonds, the credit card, comes due about every two years. Greece has to issue new bonds to pay off the old bonds - the sovereign equivalent of getting a new credit card to pay off the old credit card. At some point the required bonds were more than Greece could believably pay off, that's when the trouble started. They can't get approved for the new credit card to transfer their balance.

What happens now? Many, me included, think Greece should be allowed to default, as there's no chance their government can cut enough employees, drop pay, cut benefits, and raise taxes enough to pay off these bonds. But that would hurt major French, Swiss and German banks. So, in Plan B, Germany, France, and the IMF (which is substantially funded by the US) will buy the Greek bonds, thus putting off the day of reckoning for a year or three. Instead of the banks, who are supposedly experts in quantifying risk, paying for their bad decisions, the German, French, Swiss and American taxpayer will pay. How much will this cost the taxpayers? Between $100b and $200b. However, now the precedent is set for Spain, Portugal, Italy. Those bailouts are estimated to be five times large, so they will cost $500b to $1t. Club Med is going to cost more to clean up than Wall Street.

I went to the doctor this week. I was given a prescription, Efudex. I went down to the Kaiser Pharmacy and bought it - $349.10 for a 1.5oz tube (about the size of a travel toothpaste. Apparently this stuff is made from Unobtainium, the stuff that makes the mountains float in Avatar.) I got home and called Walmart - $244 for the same stuff. I called to see about returning the unopened tamper-proof package. FDA law, drugs can't be returned ever. Isn't that convenient? Then I did an internet search. has the same stuff, $66. They also have a generic, $19. We're being ripped off each and every day. Kaiser is the same people who are trying to bill my son $19,000 for an emergency room visit where he did not even require a band-aid. My advice: get your prescriptions to go, and check around for pricing. Me and my doctor will be having a little chat.

Lately, I have no ideas for the special topics that used to be an entire blog once or twice a month, so all I have to write about is current events. I decided back in January that this meant my blogs would be getting shorter: Oh well. But in fact they've been getting longer. We live in "interesting times," as the Chinese curse goes.

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