Perception Deception and Debt
 Submitted By Michael Michaud
Perception, Deception and Debt . . . More Volatility to Come by Van Tharp Institute
In last two week’s discussion on Greek debt, I concluded that uncertainty and hence volatility would remain in the market for some time to come.
As the mainstream press latched onto the situation, the latest revelations have done nothing to change that thinking.
Deception
The most interesting report came in a New York Times article over the weekend that revealed—gasp—Wall Street banks have helped create another debt bubble. This one in Greece.
In summary, investment banks (which are now just “plain ol’ banks”), most notably Goldman Sachs, created customized derivatives or swaps to effectively loan large sums of money to Greece (and other countries in the PIIGS mess). All of this was perfectly legal, even if it wasn’t disclosed.
In essence, Greece swapped future revenues from airports, highways and the national lottery (also known as their safest and most reliable future revenue streams) for a chunk of cash then. Since the transaction was classified as a sale and not a loan, the immediate infusion of cash helped Greece meet some European Union financial guidelines in the short term (back in 2000 and 2001) and pass the problem on to future regimes.
Let’s recognize these maneuvers for what they are: an under-the-table use of financial and accounting gamesmanship that allowed a bubble to grow out of control and off the financial radar screen.
Understand, America has developed “passing the problem to future administrations and generations” to an elevated art form, so I won’t cast any stones. Additionally, the European Union debated the very issue of making such swaps more transparent in back in 2000, but decided against any new reporting requirements. Finally in 2002, disclosure requirements for these types of swaps (and the entities formed to facilitate them) began to appear.
The current “second wave” debt crisis is almost certainly deeper and wider than we currently imagine. Additional volatility and uncertainty will continue as the media uncovers more revelations about the situation.
Perception
And now for a fun guessing game on perception. Let’s look at the debt of two different governments.
All $ in Millions
Annual GDP Outstanding Debt 2010 Budget Deficit
Government A: Annual GDP $2,000,000, Outstanding Debt $75,000, Budget Deficit $40,000
Government B: Annual GDP $400,000, Outstanding Debt $443,000, Budget Deficit $50,000
Here’s the set-up: Country A has a GDP of $2 trillion, $75 billion in debt and will have a projected budget deficit of $40 billion for this year.
Country B has an economy 1/5 the size of A, has almost 6 times more outstanding debt and will add 20% more debt this year to their bottom line.
Whose bonds would you imagine have the higher priced insurance against default? Which one does the market view as riskier?
Considering the numbers provided, wouldn’t it seem that Government B would have the higher risk for defaulting on its bonds?
Alright, this was a trick question. Government A is actually California. And Government B is Greece.
As strange as it may seem, California had the higher default insurance up until two months ago. California was viewed as a worse credit risk than Greece!
What changed? One thing—perception.
Until December, California had to pay more for bond insurance than Greece did. California’s problems had been in the news for a long time by that point and were very high in the public’s awareness. Since the first of the year, Greece’s debt problems have been in the news more. Now that more people are aware of the issues, the price for insuring against Greek default has risen dramatically.
What a strange game. If one wanted to speculate in government bonds today, it looks to me like buying California bonds and selling Greek ones might be the way to go.
Resolution
In the end, the two primary Greek creditors (France and Germany) will not allow it to default. For the EU, Greece falls into the same category that the American banks and AIG did last year—“too big to fail.” A default on Greek debt would send the EU into a tailspin that most would consider catastrophic. That could lead to the end of the economic conglomerate and create severe financial hardships for member countries in terms of cost of capital. So the member countries will do everything in their power to keep that from happening.
If Greece is too big to fail, then what about California? It’s five times bigger… Some opine that the California debt insurance is as high as it is because the US federal government has given no indication that it will step in to help. But I think that it is a rather safe bet that the U.S. governmental powers-that-be will not allow a California default under any circumstances short of financial Armageddon.
So in the meantime, someone is enjoying the benefit of writing really high-priced California risk insurance.
Until the EU creates some concrete plans for resolution the PIIGS debt problem, look for the volatility in the equities markets to continue.
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