Thursday, July 14, 2011

Sovereign Debt: Confidence Game

Earlier this year I read the book "Endgame; The End Of The Debt Super Cycle And How It Changes Everything."  It is by far the best finance/economics book released this year.  It takes a very brief moment to discuss how we got here, then looks at where we are going and why.

The introduction to the book talks about why a crisis occurs.  What triggers it?  This is a fascinating question to me. 

They compare it to a large pile of sand that was built spec by spec over many years.  At a certain point, one additional piece of sand will fall on the pile and create a mini avalanche that changes the whole structure.  But how do you know which piece of sand will create the fall?  Was it the one additional spec that fell, or all the pieces that built up over the years?

This is exactly how a debt crisis occurs.  At some point the market loses faith in a bond market, and then it is just over.  You can see it coming for years in advance, but to predict the moment it will occur is impossible.

For example, analysts began arguing that the real estate market was in bubble territory as early as 2002, and banks were already beginning to loosen lending standards and create loans that had very little chance of performing without consistently rising prices.

But it wasn't until 2007, 5 long years later, that the mortgage market began to implode.  Two small subprime hedge funds owned by Bear Stearns announced that they were closing their doors due to defaults.  This was the piece of sand. 

As an investor you can easily study the financial statement of Italy and determine that their bond prices staying stable in value depends on their ability to borrow additional money in the future to pay off current debt.  In the past week the interest rate on their bonds rocketed from under 5% to just under 6%.  The value of the bonds went into free fall almost overnight.


A spec of sand fell on the pile this week and created the small avalanche.  But what was the trigger? 

Investors could have decided just as easily that they were going to sell Spanish debt.  I have been discussing for months that after Greece, Portugal, and Ireland, the next catalyst would be either Spain or Italy, but there was no way to know which country the bond market would turn on first.

This same exact scenario will occur with Japan, the United Kingdom, and the United States this decade.  Today interest rates on United States debt are at all time historical lows.  Rates for Greece were almost identical to the United States 2 years ago.

It was obvious that subprime homeowners that made $25,000 per year and bought an $850,000 home back in 2006 could not make that payment.  The loan would default unless they could flip the home for a higher price.  At the time the loan was rated AAA and investors purchased the loan for close to the same interest rate as a government bond.

Then the piece of sand fell in February 2007 with the Bear Stears hedge funds. Just like the piece of sand fell for Greece in March of 2010, and fell for Italy on Monday this week.

The following graph shows Italy's debt to GDP ratio meaning how much debt they owe compared to how large their economy is.  It is very close behind Greece. 


An investor could have looked at this information last week, yet prices for their bonds traded at close to risk free valuations.  This week prices collapsed.

We are entering a time where the paradigm we have lived and invested in is going to completely change.  You need to understand not what it means when your country enters a recession, but what it means when your country goes bankrupt. 

One morning you will wake up and the piece of sand will fall that triggers a run on the United States bond market.  It could be tomorrow.  It could be 6 years.  But it is coming.

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