BFP Management Blog

Archive: June 2010

European Hangman

In the March 2010 issue, I discussed the “Modern Day Greek Tragedy” and their sovereign debt problem. Only months later, the issue is getting much more problematic and is spreading.

Blog 0610 #1

The Greek 2-Year bond yield soared as the European Union (EU) only discussed a bailout. Investors demanded higher yield (interest) on Greek bond investments. Without the EU or International Monetary Fund (IMF) stepping in with a low interest loan, the squeeze of market rates (18.9% on April 26th) will avail less money for government projects as more funds would be needed to service the debt.

Chart 1

Blog 0610 #2 Ed

While the European Union (EU) has been slow to bail Greece out from its overspending as the Germans (the largest/strongest economy in the EU) seem to want the issue to sink in before authorizing far cheaper financing, it is clear that the EU and other countries do not want a Greek bankruptcy. An EU country going bust would spread panic since other countries are in a similar predicament and borrowing costs would show a similar pattern to Chart 1.

The so-called “PIIGS” (acronym for Portugal, Italy, Ireland, Greece and Spain for EU countries with massive sovereign debt issues) have become the focus of bond markets, the EU and the IMF. A bailout involving the IMF is all but certain for Greece and then the rest of the PIIGS. It should be noted that 40% of IMF funds come from the US taxpayer.

Blog 0610 #3

The conundrum facing the EU is how do you bail everyone out? Of the two choices, drastically cutting spending or borrowing more, the politically expedient solution around the globe has been to increase debt and delay significant cuts (kick the can down the road). Goldman Sachs and JPMorgan Chase have estimated that to “save” everyone, it would cost approximately $800 billion. At the same time, these countries who will be borrowing more will have to concede to some cuts in spending. That is always unpopular and the mere discussion has caused riots in Greece and protests in France (after President Sarkozy proposed raising the retirement age). This will also lead to recessions if the countries aren’t already mired in one.

Chart 2

Blog 0610 #4

Source: Eurostat

Why should we care about the debt problems of the PIIGS and will they affect us? The short answer is absolutely. Increased borrowing worldwide is coming at a time when the largest economy in the world (ours) is financing approximately $.39 of every dollar spent at the federal level. We also have sub-sovereign (states, counties, cities) debt/liabilities that are expanding. For example in California, an independent study found that pension liabilities (for the Golden State alone) are under funded by more than a half trillion dollars.

Over the long term, interest rates will be going up given the massive amount of money being borrowed worldwide. Government obligations (i.e. social security, worker pensions) and services will be cut so anything previously promised will be realized below current expectations.

As a practical example, I am under contract to purchase an apartment building in Los Angeles County. While the adjustable rate loans available are very cheap, I will likely opt for a 10 year fixed rate.

While I would like increased profits thanks to that lower adjustable rate mortgage, when European Hangman completes and many billions more are borrowed, I don’t want to be out shopping for a loan. Higher rates would be a double whammy if government spending cuts cause the economy to worsen.

On the bright side, your bearish economist is seeing some deals (albeit needing repositioning) that make sense to me. That is the first time I’ve said that since 2002.

Kyle Kazan

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