Trading
Tip
 Perception,
Deception and Debt – More Volatility to Come
by
D.R. Barton, Jr.
In last 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
|
$2,000,000
|
$75,000
|
$40,000
|
|
Government B
|
$400,000
|
$443,000
|
$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.
Great
Trading!
D. R.
About
D.R. Barton, Jr.:
A passion for the systematic approach to the markets and
lifelong love of teaching and learning have propelled D.R.
Barton, Jr. to the top of the investment and trading
arena. He is a regularly featured guest on both Report
on Business TV, and
WTOP News Radio in Washington, D.C., and has been a guest
on Bloomberg Radio. His
articles have appeared on SmartMoney.com and Financial
Advisor magazine. You may contact D.R. at
“drbarton” at “iitm.com”.
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