S&P downgraded Greek debt by three steps to BB+, which puts it firmly into the Junk category. This is about as big a surprise as when they put subprime mortgages on a 12-step program, long after the markets had figured out that most of them were total crap.
Somewhat more surprising, but not shocking, was a two-step downgrade of Portugal to A-. That is still investment grade, but is pretty shaky for a sovereign credit.
The markets have figured out that Greek debt has problems, but the downgrade caused rates to rise even further for Greek debt, with its two-year paper yielding over 26% at one point. That means the markets think that Greece is the worst credit risk in the world, even worse than Venezuela. (OK, there are several countries that can’t float bonds at all, and are 100% dependent on World Bank financing — places like Upper Volta — but they really are in a different category altogether.)
The downgrade of Portugal was the thing that really stoked the fears of contagion. While Portugal is still treated with far more respect in the markets than Greece is, things are rapidly going the wrong direction. Yesterday the yield on the Portuguese two-year note jumped 93 basis points to 6.24%. Another one of the PIIGS ( Portugal, Ireland, Italy, Greece and Spain), Ireland, also saw a big jump in its two-year paper, rising by 90 basis points to 4.64%.
Just as a point of reference, yesterday U.S. 2-year T-notes were yielding 0.95%, or roughly the one day increase in rates in Portugal and Ireland. Most of the bailout funding for Greece is going to be coming from Germany, where the deal is extremely unpopular. Incidentally, Germany has elections coming up, and German politicians are just as sensitive to such things as our politicians are. Here in the U.S., there is still widespread opposition to having bailed out our own banks, even though doing so saved us from a second Great Depression, and the ultimate cost is proving to be FAR lower than anyone thought it would be at the time the funds were voted on.
Still, Germany can handle one bailout, but two? If it goes to two bailouts, who is to say it will stop there? Greece and Portugal are pretty small fish, but if they go down, it increases the odds that countries like Spain and Italy could follow. I still think that some sort of arrangement will be worked out for Greece, but time is running out, since on May 19th they have an 8.5 billion Euro bond payment due.
There will be a lot of pain involved in any such arrangement, both for creditors and for the people of Greece. One of the better measures of how much trouble the market thinks a country is in is the price of insuring against default by the banks in the country. The graph below (from http://krugman.blogs.nytimes.com/2010/04/27/the-cohesion-crisis/) shows that the market has very real concerns about the Iberian Peninsula, but is still pretty confident about Italy, France and Germany. If the rate for Greece were shown on the same chart, it would be impossible to see the differences between the countries shown.
The core of the problem is a structural one in Europe. Imagine for a minute if the U.S. never passed the Constitution and remained with the Articles of Confederation. That it had a common currency, and a free trade pact among the states, but no real national government. That is more or less the position Europe is in. Very importantly, the social safety nets — which tend to be much larger in Europe than they are here — don’t cross the boundaries. Each country runs its own fiscal policy, but they have a common monetary policy.
The classic policy response to the situation Greece is in would be to devalue the currency, which would cut down on Greek imports and help stimulate their exports, or in the case of Greece, would have made it a more attractive tourism destination. However, since it is part of the Euro, it can’t devalue. Even if the Euro gets weak, as it has so far this year, falling about 13% against the dollar, it really doesn’t help Greece out that much. Most of the tourists would probably be coming from Germany and France anyway, and a weak Euro does not make travel to Greece any cheaper than a strong Euro does. In the U.S., an individual state can get into budget trouble, but still keep going.
Imagine for a minute that Florida was running a big deficit and had to cut back spending or raise taxes, but all those Florida Social Security recipients had to rely on the checks coming from Tallahassee and not Washington. Then imagine that people in the country first and foremost thought of themselves as New Yorkers or Virginians, not as Americans. How popular would a bailout of Florida be if Florida had been granting ever more generous retirement benefits to its people and then ran into a fiscal crisis?
Well in Europe , most people still think of themselves first and foremost as French or German, and only secondarily as Europeans. Thus, it is easy to understand the reluctance of the German people to bail out Greece.
However, if Greece were to default, it would throw the Euro as a whole into doubt. The dominos would then really start to fall. Greece cannot really pull out of the Euro and go back to the Drachma; if it did, it would trigger the mother of all bank-runs. The German Banks like Deutsche Bank (DB) are thought to be heavily exposed to Greece, so there is some incentive for Germany to help out Greece, but it is not the sort of thing that is going to sit well with the voters of Frankfort and Munich.
Eventually, I think that Germany and the rest of Europe will cut the check, but not before some very harsh conditions are imposed on Greece. Those conditions are not going to go well with the people of Greece, and major protests and strikes have already occurred. Greece will have to cut its equivalent of Social Security payments, not just for people far in the future, but the check going to Grandma today. It will have to raise taxes, most likely the value-added tax, since the income tax in Greece is never paid by anyone. It will have to lay off civil servants at every level of government.
In short, the Greek economy is not going to be reviving anytime soon. The holders of Greek debt will probably have to take a haircut of some sort, most likely in the form of a restructuring where the maturities of the debt are pushed out, and possibly the interest rate on the debt cut. So a 3-year note with a coupon of 5% (and now yielding around 20%) will become a 10-year note, yielding 4%.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
More about Zacks Strategic Investor >>
Read the full analyst report on “DB”
Zacks Investment Research
