Sovereign Credit Risk

2010 will be known as the year of Sovereign credit risk as 2008 became know as the year of the housing bubble. In many ways, the credit crisis swirling around Europe is similar to the mortgage meltdown. Taking on debt that you cannot pay for is epidemic. Borrowing to pay for current consumption creates a false sense of wealth. At some point, you have to pay it back. Or those holding the debt have to forgive part of all of what you owe. If they do, they face financial ruin. There is no easy answer.

Greece and other European countries ran large deficits to pay for current consumption. Now someone has to pay for their excesses. Those holding the debt, primarily European banks and governments, want to be paid back. Citizens in Germany who have been careful with their money do not want to be saddled with covering the debts of Greece. The European banks cannot afford to write off the debt as they are recovering from the affects of the U.S. mortgage meltdown.

Since European banks are at the center of sovereign credit risk, many large investors, fearing the affects of the credit crisis, are moving their money to safer investments in other countries such as the U.S. As money flows out of Europe, the banks see the outflow of money causing their capital structure to deteriorate. Should one bank fail it will have a cascading affect on others, not unlike the sequence of the subprime defaults that began with HSBC’s Household Finance disclosure of mortgage losses in February 2007. The losses grew and expanded to other firms, eventually leading to the collapse of investment banking houses Lehman Brothers and Bear Stearns.

The global trade and the banking system connects everyone. It is easy for money to move from one investment to another as capital flows from one country to others seeking higher returns, with lower risk. For example, the benchmark ten-year Treasury rate fell 47 basis points as investors sought the safety of U.S. Treasuries. This outflow of money negatively affects the European banks as they lose deposits.

Following Bernanke’s Model

To stem the fallout from the Greek credit crisis, finance ministers from the 16 European Union accepted the need to provide more than €100 billion ($146 billion) over the next three years. Leaders hope these funds (€80 billion from the EU and €30 billion from the International Monetary Fund) will replace the commercial borrowing in the financial markets between now and 2012. Their goal is to buy Greece time to bring its deficit under control through drastic cuts in public spending.  Greek authorities committed to cuts in public spending and higher taxes amounting to 13 percent of the countries GDP over the next four years. To accomplish this, the Greek government is cutting public sector salaries, raising the retirement age for women and imposing new taxes.

Essentially, the Europeans are following the Federal Reserve Chairman Bernanke, model he used to avoid the collapse of the U.S. banking system from the subprime mortgage crisis. Bernanke, a student of the 1930’s depression, identified that liquidating debt was the reason the world fell into the prolonged depression during the 1930’s. By transferring private debt to public accounts, he avoided the massive contraction of the U.S. economy that would have occurred had banks and individuals written off the debt similar to the depression.

However, these bailout programs transferred the bad debt from the failing institutions to governments. The idea was to place the bad debt on the public’s books, giving everyone time to work out a better solution. In another form of financial engineering, the government thought they could undo the fallout of the bad debt stemming from the housing bubble. Rather than recognizing the losses quickly and placing the assets into stronger hands, the government transferred the excessive leverage to government books.

With the Federal Reserve keeping short-term rates near zero, it is facilitating the transfer of debt from weak organizations to the government. German Chancellor Merkel has stated that if the IMG-led austerity program for Greece succeeds, the package of rescue loans will make a profit for German taxpayers, since Germany can borrow money cheaply and lend it to Greece at rates of around 5 percent. Sounds great in theory. What if it does not work? What if there is too much debt to take on? This is the sovereign credit risk question.

Sovereign Credit Crisis is more than Greece

Many European countries are larger than Greece with growing debt problems. Portugal’s public debt will rise to 91 percent of Gross Domestic Product by 2011, up from 77 percent last year, according to the European Commission. Greece’s debt will increase to 135 percent of GDP in 2011 up from 113 percent last year. Spain’s percent of public debt will increase to 74 percent of GDP up from 54 percent.

The threat to European banks is real, just as they are recovering from their role in the subprime mortgage fallout. Many of these banks remain undercapitalized, meaning they can ill afford another credit crisis. Banks in Portugal, Spain, Italy, Ireland and the U.K. are at risk, according to a recent Moody’s report.

This threatens U.S. banks as they have important financial relationships with most of these banks. Remember, we are all connected. A failure of a European bank started the break down of the financial system in 1929.

The capital structure of U.S. banks is stronger thanks to the new programs recently instituted. This may help to cover some of these losses should they broaden beyond Greece.

Debt and Deficits Do Matter

A weaker Europe negatively affects the strength of the global recovery. Approximately, 20 percent of the U.S. trade is with Europe. If Europe finds its economy contracting, it will slow the U.S. economic recovery. The Greek credit crisis shows that debt and deficits do matter. Taking on too much debt that you cannot repay leads to a crisis. The only way out is to curtail spending across the board so the debt can be paid off and the capital of the banks that wrote off the loans is restored. It is a long and painful process.

By the way, according to the Congressional Budge Office (CBO) the public debt to GDP ratio for the United States was 40 percent in 2008. It will rise to 90 percent by 2020. According to economists Kenneth S. Rogoff of Harvard and Carmen M. Reinhard of the University of Maryland, countries with debt-to-GDP ratio “above 90 percent, median growth rates fall by 1 percent, and average growth falls considerably more”.

The sovereign credit crisis is not limited to a few European countries.