Note: I don’t intend for this post to sound patronizing. I wanted to make an accessible follow up to my previous post. If you want the TL;DR version, just read the first paragraph.
The sovereign debt crisis outbreak phase will look very different from the previous outbreak phase. In the previous phase, the financial sector played two different parts. Financial firms not only went bankrupt due to insolvency, but their bankruptcies triggered liquidity problems in other financial firms. This feedback loop was very fast around the time of the Lehman failure. The sovereign outbreak could unfold over a much longer period.
Countries, by and large, are much better at managing their cash flows than the financial sector giants were during the Lehman bankruptcy period. AIG and Lehman simply didn’t see the possibility of needing to post huge amounts of cash as collateral for their CDS contracts. Governments have a pretty good handle on payroll.
Greece has effectively been shut out of the long term financing window. At least, that’s the story that we’re being told. Their 10 year bonds are trading at 8%. A few decades ago, the US had to issue a few 10 year bonds at a rate north of 14%. Of course, the “spread”—comparing to other countries or to short term rates—wasn’t nearly as bad as it is for Greece right now. Greece faces other constraints as well, but the point is that 8% doesn’t look all that bad when you compare it to other times of crisis. Comparing to other countries right now, it looks terrible.
Greece is going to get a bit of a bailout from the other Eurozone countries and the IMF. That means that the US taxpayer is going to be put at risk (and we just raised our commitment to the IMF). The bailout will provide an interest rate that is much better than the market rate right now. Of course, it’s impossible to determine a “market rate” on an intervention of this scale. After all, the current rate is pricing in some probability of Greece simply refusing to pay or the IMF deal falling apart. The IMF will also ask for some pretty severe management changes in Athens. This is standard operating procedure for the IMF, but it is much more likely to result in rioting in the streets than if Athens simply gave lenders the finger.
Assuming Greece does get the aid package (sounds better than “bailout,” doesn’t it?), then Portugal is likely going to face some increase in their interest rates in the relatively near future. Unlike the previous outbreak phase, there are very few reasons for a massive liquidity squeeze in the various countries. The countries aren’t likely to run out of cash, they’re just likely to get financing terms they don’t like. However, if rates raise, downgrades may be issued. That could result in another liquidity squeeze, but it won’t be the countries facing the squeeze. It will once again be the financial sector.
Why?
Governments issue debt. They don’t write credit default swaps against that debt. The financial sector does that. When a downgrade is issued, the firms that wrote credit default swaps against that country’s debt probably have to put extra cash into separate accounts to satisfy the terms of their agreements with the firms that bought the credit default swaps. That’s the posting of collateral that caused the financial sector to seize up in the last outbreak. So once again, the financial sector will play the part of the liquidity constrained weasel. This will, in turn, cause problems for the various countries that need to issue debt. Their rates will rise, and some bond auctions may fail as their major bond buyers (the primary dealers) face cash-flow problems. Some auctions will get canceled. Eventually, some government will have a problem paying a bill.
It is possible, though unlikely, that Greece will not agree to the terms of their aid package and voluntarily default on some of their debt. I’m not sure how they’d go about doing this, but it would likely involve some negotiations with bond holders, not an outright sovereign bankruptcy. I say with some confidence that this would be the better outcome for Greece and its citizens, but a horrible outcome for the rest of the world. A Greek default would immediately cause the sovereign downgrades and the liquidity problems in the financial sector. Interest rates for Portugal, Spain, and Italy would jump higher. At this point, interest rates on US debt would probably plunge (Treasuries are still a flight-to-safety target). Gold will shoot through the roof.
But, let’s assume that the aid package does go through. When will Portugal face problems? It could happen right away, but it could take as long as a year. I’ll split the difference and say six months. That’s a couple quarters for GDP growth to ease the problem, potentially reversing the slow collapse. I’m not very hopeful, but I wouldn’t feel comfortable placing bets this far in advance, either.
Anyway, it’s possible that the sovereign debt crisis actually manifests in another short feedback loop within the financial sector, but it is much more likely to play out slowly, with a rather accommodating time-line. We’ve got two actors in the play this time, not just one.
