2 Cents writes about personal finance, economics and life balance at Balance Junkie. Check out the site, then subscribe via RSS feed or follow on Twitter @BalanceJunkie.
The news headlines have been full of one bad Greek pun after another: Greece is the word. It’s all Greek to me. My personal favourite so far is: My Big Fat Greek Bailout. So what’s the big deal? Why are politicians, bankers and economists suddenly stricken with an uncontrollable eye twitch whenever anyone mentions the prospect that Greece may have to default on its enormous pile of debt?
In a word, it’s contagion. People are worried that if the Greek government defaults on its debt obligations, it could have ripple effects throughout the global economy in much the same way that the defaults of numerous American homeowners triggered the subprime mortgage crisis. Global markets and financial institutions are so interconnected today that it’s difficult to sort out who owes what to whom. Just take a look at how all this global debt is so tightly woven:
Europe’s Web of Debt
For a closer look, please visit this link or click on the image below, then zoom in.
Image from New York Times.
Of Bonds & Bunds
Most countries issue debt in the form of bonds. A bond is basically an I.O.U. whereby the borrower (in this case, a country) agrees to pay the lender (a bond investor) a coupon or specified amount of interest over a certain period of time. Once that period of time is up, the borrower has to pay back the principal. With the massive amounts of debt out there right now, you can imagine how giant this market is.
If the market suspects that a borrower will not be able to honor their obligations, bond traders will begin to sell those bonds. That drives the price of the bonds down and the yield (interest rate) up. That’s why you’ve heard feverish business journalists reporting on “spreads widening” on Greek bonds. That just means that the spread, or difference, between the yields on Greek bonds and those of comparable instruments (usually German bunds or U.S. Treasuries) of the same term are getting bigger. For example, at one point the Greek 2 year bond carried a yield of 16% compared to about 1% for a 2 year German bund. (That’s not a typo. It’s just what German bonds are called.)
Oh, What a Tangled Web We Weave . . . Spotlight: Derivatives
In addition to regular exposure to Greek default risk through bonds, a lot of market players may be exposed through credit default swaps (CDS). This is a derivative that allows the purchaser to buy insurance in case of default. If the borrower were to default, the issuer of the CDS would have to pay up. So investment banks that wrote CDS on Greek sovereign debt would face potential losses. However — and this is where it gets really confusing — those banks may have somehow hedged their exposure so as to limit their losses.
Sorry for the melodramatic subtitle, but hopefully you can see and appreciate why so many people are worried about derivatives. In the marketplace right now, we have derivatives of derivatives of derivatives. It’s like a giant knot in my son’s yo-yo string and it’s really hard to untangle because no one knows for sure who’s exposed, how they’re exposed, or to what degree they’re at risk. That’s why there’s been such a huge cry to put these things on an exchange where they can be traded transparently.
The European Sovereign Debt Crisis and Your Investments
After all this talk of bonds, bunds, and derivatives, we come back to our original question: Why should the average investor in America care what’s going on in a tiny country like Greece? Banks in Germany, France, and elsewhere in Europe hold a fair amount of Greek debt and stand to lose a lot if Greece defaults. And it’s not just Greece. Spain, Portugal, Italy and Ireland also have looming debt problems, to which banks worldwide (including American banks) have exposure. By the way, the U.S. and U.K. balance sheets are pretty ugly too.
The real risk for investors (and for everyone, really) is that global banks can run into a situation like the one that occurred around the time Lehman collapsed where none of them trusted each other. Interbank lending would again grind to a halt and paralyze the financial system. Global markets would be beset with panic selling, causing all asset prices to fall as they did during the recent financial crisis.
Will this scenario play out again? No one knows for sure if or when it might happen. But the risk is there. If you have a shorter investing time horizon (less than 10 years until retirement), you may want to pare back your exposure by shifting some money into cash. If you have a longer horizon and you’re comfortable riding out another storm, stick with your current plan. It just pays to be aware that it’s not exactly business as usual in the current economic climate.
{ 10 comments… read them below or add one }
I think you focus a little too much on Greek debt as the cause of the problem. Yes their debt is too high, there is no question about that. But the real straight jacket that is making the situation far worse for them is the Euro.
Greece’s economy had a huge bubble which drove up the pay of their workers along with the general price level. Now that the bubble has burst, investment has left Greece because their products and services are overpriced. Capital can leave the country but workers cant (and wont) quite as easily.
This could be a much better situation for Greece if they had their own currency because it could be devalued relative to their neighbors, making their goods and services reasonably priced again. But given that they are stuck with the Euro, they don’t have the authority to do that. This means they will be stuck with poor economic growth for much longer because deflation is the only way for them to become competitive again.
It was very interesting to see how the yields on Greek debt increased dramatically and even forced the Germans to get on with it and come up with the bailout, which everyone knew they eventually will.
You make some good points Edwin, but even if the Euro didn’t exist there are so many countries in the same boat as Greece that it would simply become a race to the bottom in terms of devaluing currencies. I think we may eventually see some type of competition among many debtor nations (the U.S. and the U.K.) to devalue in order to offset the effects of their untenable debt loads.
I think the Greek economy was more than a bubble. A recent article in the Financial Post described it as a Ponzi scheme. This article was written by a guy who did business there. It’s an interesting read, to say the least.
The situation is definitely more than just me calling it a bubble, but I didn’t want to go into that too much as it’s not directly relevant. Currency devaluation can be somewhat of a race down but it wouldn’t actually become an issue unless it was nearly every country in the world (but in that case you wouldn’t have to devalue).
The fact that Greek products and services are overvalued means that other countries are able to offer them for cheaper. Devaluation would just make it that Greece is competitive but that wouldn’t force other nations to devalue just to keep up as they are already doing fine (relatively).
This is the first PF blog that I’ve seen talked about the Greek debt crisis. Just wanted to say I really appreciate the macroeconomic perspective. Sometimes PF blogs are so caught up in the minutiae of frugality or 401ks that they severely lack the insight into the “bigger picture” or the macro scale of the economy.
To paraphrase Maggie Thatcher, “the problem with socialism is that sooner or later you run out of other people’s money.” There is a sovereign debt problem throughout the world. It’s not just the PIIGS. Some countries like the US will get out of the problem by printing their own money and debasing the currency through inflation. The EU has real problems in front of it with their single currency and mix of countries that are fiscally responsible (relatively speaking) and those that aren’t. How many bailouts can they do before it all starts to fall apart?
Manshu – Bond traders are pretty powerful. They will determine how this plays out. James Carville is famous for saying that if he were reincarnated he would want to come back as the bond market!
Eric – I’m sure a certain number of readers (and bloggers) tune out when I write about macroeconomics, but I’m glad you liked the article and I’m grateful to SVB for posting it with the terrific graphic she found!
Biz of Life – I love the M. Thatcher quote! I think you’re right. All of this will come to a head at some point. Sooner or later, by choice or by force, the world will deleverage. I’m just not sure exactly how or when it will happen and I hope it’s not too messy once it does.
I just got my dose of economics for the week. (: Not usually my thing but you did a good job of explaining the importance of Greece.
I appreciate the information on the Greek crisis. I’m wondering what you know about how these things usually play out in the long term. Obviously it depends on whether Greece defaults or the Euro zone bails them out.
However, if I’m exposed through mutual funds that emphasize foreign stocks and even some sovereign debt, and I “ride it out” what does that look like in 3-5 years if Greece defaults and the contagion is contained? What about if Greece doesn’t default? My portfolio has obviously taken a hit in the last week or so, and I’m just trying to figure out whether it is worth sticking it out (i.e. if I wait long enough, will these types of funds recover) or getting out before it gets any worse (i.e. I’ll never recover the money lost by staying in foreign funds with sovereign debt exposure, so better to get out now).
Any thoughts on that (I know it is a fairly specific question)?
I would have to be clairvoyant (or a lot smarter than I am) to answer your questions accurately. The great challenge of the current situation is that it creates uncertainty. Uncertainty creates volatility. I expect large market swings in both directions over the next few months and maybe years as we alternate between the view that it’s hopeless and the view that it’s all fixed. I assume that we will emerge from this at some point. What I don’t know is how long it will take and how much damage global portfolios will sustain in the process.
I’m writing a series on the issues we are facing all this week. In the meantime, if you’re worried, there’s nothing wrong with lightening up on days where the market thinks it’s all fixed. How much you want to take off the table depends on your individual situation in terms of time horizon, income level and stability, risk tolerance, etc. Your questions are very relevant and I suspect more and more people will be asking them as this unfolds.
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