Marc Gayle

The single most important factor in financial markets is confidence. Confidence in everything. From the political system to strength of the local currency to regulators to central bankers. In October 2009, the new Greek Prime Minister shattered market confidence by announcing that several revisions have to be made on their reported numbers (i.e. they have been lying) starting with the budget deficit being double previous estimates @ 12.5% of GDP. As a result of that announcement, which was the absolute right thing for the new Prime Minister to do, the credit ratings agencies downgradedGreece’s debt.

The new Greek government kept dithering about whether or not they need assistance. To further compound the issue, the EU and IMF were back and forth about whether or not they would come to Greece’s rescue. The first version of the bailout plan was only 25 Billion Euros. Even when this was presented, the markets were still not convinced that everything would be ok. EU leaders and the IMF were forced to go back to the drawing board and come up with a more ‘potent’ solution. A $147B bailout package was put together, that seems to have soothed markets fears about Greece’s problems. However, the steep austerity measures demanded by the IMF and the EU didn’t sooth thefears of the Greeks who will have to pay dearly for the years of profligacy by their elected officials.

Just when things were being contained in Greece, S&P downgraded Portugal &Spain’s debt. This causes panic among investors as stock markets all over the world start to decline. The EU is forced back into a corner, and has no choice but to fight. Come out swinging they did. The EU leaders, IMF and the US put together a $1 Trillion bailout package for all troubled Euro nations.

So, in summary…we have seen a small country that first ‘needed’ a $25B bailout, turn into a large $1T bailout for the entire EU (basically). What exciting times we live in. If it is one thing these regulators seem to have learned, it is that fear and uncertainty can spread contagion all over the world in no-time flat. They seem to have tried to get in front of it this time. Although…there are early signs that there are still doubts. Hopefully, this is another crisis diverted.

P.S. Image courtesy of chrissys575 on Flickr.

What causes a government debt crisis?

Typically, governments carry a certain amount of debt on their books as standard operating procedure. These are in the form of bonds. A ‘normal’ amount of between 20% – 65% is usually fine, for most countries. This actually works well, because when the fiscal situation of the government is in good order (i.e. when the government is earning enough to cover the interest on the debt + invest in infrastructure and projects that produce growth) the government is actually doing investors a huge service by providing a ‘risk-free’ asset for them to include in their diversified portfolios. The crisis comes about when the government’s debt-to-GDP ratio reaches to dangerous levels (usually 120%+) and the fundamentals of their fiscal situation becomes shaky. i.e. either GDP growth slows/stops, revenue measures are inadequate (taxpayers avoid paying their fair share by bribing officials), spending gets wildly out of control, or any combination of the three. The result of this is that the ability for the government to honor their interest payments becomes in jeopardy.

What caused Greece’s debt crisis?

So Greece, unfortunately, has a combination of those factors. According to Greece’s Ministry of Finance (PDF), up to 2007 Greece had GDP growth rates of between 2.5% and 5% from 1996 – 2006. However, as later posts will show, it is important to note that perhaps those GDP growth figures are now to be taken with a grain of salt – as it has been revealed that previous administrations have been ‘cooking the books’. The following image shows a nice comparison of Greece and the rest of the EU during that period:

From the report, one of the things they show are the levels of government revenues (as % of GDP) and government expenditures from 2006 – 2009. This is what it says:

Gov. Expenditures: 2006 = 43.2% of GDP; 2007 = 45%; 2008 = 46.8%; 2009 = 50.4%;

Gov. Revenues: 2006 = 39.3% of GDP, 2007 = 39.7%; 2008 = 39.1%; 2009 = 36.9%;

You can generally see that the trend should be reversed. The expenses should be going down, while income goes up! The increasing expenses can be attributed to generally powerful labor unions, and free-wheeling politicians that promise more than they probably should.

Conclusion

We have seen, in Part One, that the fundamentals of the Greek economy started to falter before the economic crisis hit. In other parts we will dive deeper into what caused the sudden surge in anxiety and possible contagion effects. If you have any questions that you would like me to address, please feel free to let me know in the comments section below. I have a general guide of what I want to cover, but I am fairly flexible.

P.S. Image 1 courtesy of titanas on Flickr. Image 2 courtesy of Wikipedia.

The New York Times has a wonderful post that illustrates the web of debt weaved in Europe.

To read the full post, click here.

The Wall Street Journal recently had an article about the Fed getting ready to start off-loading the $1.1T worth of mortgages they bought during the crisis (in an attempt to save the banks).

From the article (note, I added emphasis):

At $1.1 trillion in holdings of mortgage debt guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae, the Fed owns roughly a fifth of all these outstanding instruments.

Some Fed officials are pushing for a more aggressive approach. In April, Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, called for monthly sales of $15 billion to $25 billion to eliminate the Fed’s mortgage holdings within five years. “It is likely the Fed will have to sell a nontrivial amount of its MBS holdings,” he concluded. Some Fed policy makers—among them Charles Plosser of Philadelphia, Jeffrey Lacker of Richmond and Kevin Warsh at the Fed board—are sympathetic.

At first glance, so much money has been thrown around in the media that 1.1 Trillion Dollars seems like it’s not so big. To put it into perspective, let’s look at some prospective buyers and see how much they would be able to buy and how long they would last:

• Berkshire Hathaway (BRK.A) – According to Google Finance, Warren Buffet’s investment company had approximately $30.5B in cash and short-term equivalents at the end of the last fiscal year. Assuming they have the same amount of cash (which is probably inaccurate, but just simplifying), and also assuming that Warren Buffet wanted to buy as many mortgage backed securities from the Federal Reserve as he could get his hands on, and also assuming that he was prepared to use all of his cash to do so…he could only participate in a maximum of 2 months (let’s call it 1.5months) worth of sales by the Fed – before he runs out cash. So that’s one large investment company down, with only 58.5 months of sales to go.
• Goldman Sachs (GS) –  had approximately $38.21B in cash and short-term equivalents. So they would be able to participate for 2 months. So only 56.5 months to go.
• The largest hedge funds in the World – with total assets under management of approximately $530B, if they were able to ‘magically’ liquidate their holdings and purchase from the fed…that entire process would take between 21.2 – 35.33 months. So only 25 more months to go (assuming some middle ground between both values is chosen).
• Google (GOOG) – had $24.5B cash on hand. So they can play ball for approximately 1 month.
• Microsoft (MSFT) – had $31B cash…so they can last 1.5 months as well.
• Coca-Cola (KO) –    Only has $9B, so they can’t even sit at the table and participate (again, this assumes one company per month, to get the shortest time of getting rid of the mortgages as possible).
• Apple (AAPL) – Has $24B, so they can participate for 1 month.

Only 21.5 more months to go.

I know this is a major simplification, it’s just an interesting exercise to look at. Especially in this media climate with hundreds of zeroes thrown all over the place. Also note that I have not included large pension funds, retirement schemes, etc. that typically have very large wads of cash…mainly because those funds tend to be abstract to most people. When you see companies constantly in the news, it’s easier to visualize how big the Fed’s balance sheet is.

Hope that puts it into perspective.

Another thing I have been thinking about lately, is the part of the proposal that will regulate the financial industry (I am pro reform) that creates a ‘bailout kitty’. i.e. the liabilities of large financial institutions will be taxed and stored in this kitty. What I am wondering is this: Where will that money be invested and who will manage it? If they (the managers of said kitty) ‘play it safe’ by investing in sovereign debt, which country’s debt? Won’t that create some perverse incentive for countries to keep running fiscal deficits because they have a literal ‘large pot of gold’ sitting down at their disposal that will allow them to finance any program they want to finance? i.e. moral hazard of the political sort.

Not saying the liabilities shouldn’t be taxed, and the kitty not created…just saying…it might have unintended consequences that are not currently being discussed. However, that might be the subject of another post.

P.S. Image courtesy of Mykl Roventine on Flickr.

However, there is a little bill that was passed in May 2009 that I, personally, have directly seen the effects of. 

Below is one of my credit card statements as of February 2010:

Contrast that with my statement from March 2010:

March is COMPLETELY different. Breaking down how much I will pay total if I stick with the minimum payment or if I paid a higher amount. It doesn’t matter much to me, because I always pay more than my minimum, but it just jumps out at you how much you are paying in interest.

That, is change I can believe in!

P.S. Image 1 courtesy of Andres Rueda on Flickr.

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This decision tree summarizes how the Fed responds to potential financial crises. After getting a reading on the economy’s vital signs, the Fed determines whether the threat at hand might compromise the central bank’s three primary goals.

If the Fed sees little risk, no action is taken, avoiding moral hazard and leaving the markets to sort out the difficulties. The Fed reacts this way to nearly all potential troubles in the financial sector.

A pervasive threat to the overall economy or the financial system can justify direct action. The Fed rarely makes these interventions; when it does, it strives to manage the resulting moral hazard in the least costly way.

The first choice entails the Fed’s acting as an outside coordinator to bring together private institutions to defuse the threat. It’s a strategy that minimizes public-sector risk, and the central bank used it with the Long-Term Capital Management hedge fund in 1998.

When this option isn’t feasible, the Federal Reserve Act provides the authority to deal directly with pressing threats. The preferred strategy involves forging partnerships with private institutions, a course the Fed took in March 2008 with Bear Stearns, a troubled investment bank and brokerage with sufficient remaining collateral to support the intervention.

When private partners aren’t willing to step up, the Fed can act alone if troubled firms still have sufficient collateral. In September 2008, the Fed arranged a purely public intervention for AIG, a huge financial services company.

If remaining collateral is insufficient to support taxpayer-financed actions, the Fed under current law is obliged to let the markets decide a troubled firm’s fate. The Fed accepted this outcome with Lehman Brothers in 2008.