This Debt Crisis Has Only Just Begun

As you'll see, the Greek sovereign debt crisis may have serious implications (and warning signs) for the rest of the world. First, though, let me catch you up.

The latest on Greece is that details for a potential bailout plan have been filled in,  with the European Union offering euro30 billion and the International Monetary Fund offering euro15 billion should Greece request it. Still, another new twist in the story is that the sovereign debt, or the government's debt, is not the only debt at risk of default. Now Greece's private banks could be in jeopardy.

Greek banks own the largest share of Greek government debt, and Moody's (NYSE: MCO  ) downgraded Greece's four largest banks last week, including National Bank of Greece (NYSE: NBG  ) . The scariest development is that Greece's banks are having difficulty meeting short-term financing needs. Last week, the banks asked for access to an emergency government liquidity facility. They are said to be losing counterparties on repurchase agreements. Sound like a familiar tale? This is the same way the story of Bear Stearns -- now owned by JPMorgan Chase (NYSE: JPM  ) -- began. The problem for Greece is that its government doesn't have the financial wherewithal to bail out the private banks.

To gain insight into the implications of Greece's situation for the economy and the markets, as well as sovereign debt issues that envelop the developed world, the Fool spoke with Scott Mather, sovereign debt expert and head of global portfolio management at Pacific Investment Management Company (PIMCO).

Here's an edited transcript of our conversation.

Jennifer Schonberger: How concerning is Greece's situation and really sovereign debt for the global economy and the U.S. economy? Do the greater details we received over the weekend regarding Greece's bailout change your opinion of Greece, or the sovereign debt situation?

Scott Mather: No. We [still] think it's a major concern. ... The bailout doesn't really change things. It's still the same plan. There are still implementation issues. It's unlikely that they don't have to implement a backstop. It helps with near-term liquidity, but it doesn't improve long-term funding needs ... the underlying fundamentals and inherent growth in Greece remain poor. It remains to be seen whether [Greece] can extract additional revenue growth, meet their fiscal forecasts, and grow at the rate they're projecting. Also, we've yet to see the conditions from the IMF ...

[Sovereign debt] is an underappreciated and underpriced risk in the markets in general. And we think we're in the beginning phase of people appreciating some of those risks, and beginning to come to terms with it. As far as investment theme it's something that has far-reaching and long-lasting implications. This is likely going to continue for many years.

Schonberger: So then you don't think this is fully priced in?

Mather: No, not at all. Too many people are still operating with the mentality that somehow this is confined to Greece. To the contrary, we look at the unsustainable debt dynamics really through most of the developed world right now, which projecting out a few more years for the most part without making some substantial changes or without projecting that we get some fantastic growth rates, is in a similar situation as Greece. So it's not hard to see that the problem stretches far beyond Greece.

Schonberger: What are the chances of contagion now, in your view, and who do you think is next?

Mather: While the immediacy of the problems for other peripheral European countries isn't as bad as Greece, projecting out a few years, they're not far away from Greece's situation. I think we could see the contagion spread pretty quickly ... Portugal in terms of it being a sister-peripheral country in Europe with very similar debt dynamics and problems with respect to economic growth and having a high reliance on foreigners to fund a domestic deficit. That's what's particularly at risk.

But you don't have to look too far beyond that to see countries like Spain also having a problem, and perhaps Ireland and Italy. So very quickly you get a very large share of Europe having a more immediate problem -- not to mention later on, the U.K. is not far behind.

Schonberger: America's own indebtedness is certainly an issue. What are the chances the U.S. loses its AAA credit rating, or becomes the next Greece?

Mather: On the current path we're on, it's a question of when, not if, the U.S. runs into that downgrade scenario. But the U.S. is still special in many respects and wouldn't be at risk as quickly as the U.K. ... The U.S. is afforded additional flexibility because of its status as a reserve currency coupled with the need or desire of investors to park their savings into U.S. dollar-denominated assets -- primarily Treasury bonds. It's a special privilege that can certainly be abused for some period of time, and probably longer than other countries without attracting the downgrade attention of the rating agencies.

Schonberger: Greece is continuing to float bond offerings to cover its financing needs. Is this a good opportunity for investors, or should they steer clear?

Mather: Investors should keep away until the fundamentals change. In questions of the sustainability of debt it's a different framework than simply looking at the yields, and the premium you get for liquidity and standard credit analysis. When you're in a situation such as Greece where the very ability to roll over your debt is in question, and where there is no medium-term plan to put yourself on a more sustainable path, you have to evaluate it quite differently.

When we look at the situation in Greece, it's still likely that they're overestimating how fast they're going to grow. Therefore, they're probably overestimating revenue, and how much fiscal austerity they can achieve this year. As it becomes more apparent that that's a myth, it will create more problems and pressure on Greek bonds.

Schonberger: What do you think Greece should be paying on its debt?

Mather: You have to factor in that Greece is special in some ways in that it's part of the Euro zone club. The question becomes at what price and at what level does the club come in to participate, [and] on what terms? First, if Greece were not a member of the Euro zone club, it probably would have never been able to accumulate the debt that it has. But just looking at other emerging markets, Greece would probably be yielding closer to 20% at least. People would be projecting some sort of imminent default or debt restructuring, and that's likely the level of interest rate they'd be paying.

Currently it's nowhere close to that. Now it's around 7%-8%, which reflects the fact that people believe there's a savior coming. That's a very real possibility, but one we would also caution people on. It's not always the case that when there is an outside savior and when the IMF is involved that foreign investors get all their money back. Argentina is a good example of that ... the risk reward doesn't look particularly favorable given that situation to us right now. A lot will depend on what the aid package will look like ...

Schonberger: Does Greece have the political will to resolve the budget situation?

Mather: Certainly there is a political will. The problem is there's sort of an economic fantasy. The political will has been what most people have been banking for the last 10 years of the EU experiment. But the underlying economic reality is that the economic development and situation has been diverging across the euro zone and it has exposed the vulnerability in the system, and the weaknesses of having political will without a stronger economic and fiscal union. [Note to reader: Stay tuned for an upcoming article on the future of the EU and the euro.]

Schonberger: The structural issues are creating a divide between the developed markets and the emerging markets. In light of this as well as a pick-up in the global economy as a whole, how are you advising investors invest right now?

Mather: We think the divide is important to mention. But there are many divides taking shape. It's not just emerging markets and old developed worlds. There's divides in Europe, as well that people should pay attention to. It's very likely that much of Europe will remain in recession because of the fiscal austerity that's being imposed and because of the need to deflate.

This is unlike the last 10 or 20 years in which we've grown used to seeing the world as one big economy with everything moving with various amplitudes in the same direction.

Schonberger: Is there any country today we can rightfully consider low risk?

It depends on from what perspective. One of the underappreciated risks is the sovereign debt dynamic, and that is increasingly ... going to creep into other asset classes. We think we're undergoing a regime shift where equity and real estate investors alike will have to start factoring in the debt dynamic for a particular country into their analysis.

So increasingly you'll have to factor into your projections what's going to happen to the risk premium to sovereign debt. If that risk premium, which is supposed to be the risk-free rate, is increasingly not going to be risk-free, as you talk about 5-, 10-, or 30-year bonds from countries with this deteriorating debt dynamic. So expect the risk premiums to rise not just across sovereign bonds, but across many assets. That includes things like equities, where people thought they didn't need to worry about those things.

For related stories on Greece:

Fool contributor Jennifer Schonberger owns shares of Bank of America, but does not own shares of any of the other companies mentioned in this article. You can follow her on Twitter. Moody's is a recommendation of Stock Advisor and Inside Value. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 13, 2010, at 10:06 PM, cxsmith1962 wrote:

    What about STD? Is this stock going to plummet? Would you say at its current price of US$14.59 (04/13/10) that there is much greater downside than upside? Would you expect a significant drop that would not be follwed by a bounce/return to higher levels? What is your 1 year price forecast/rang?

  • Report this Comment On April 13, 2010, at 11:58 PM, oldetoad wrote:

    Keeping the masses mired in the details - just like the media does.

  • Report this Comment On April 14, 2010, at 9:42 AM, XMFSinchiruna wrote:

    Yet another terrific article, Jennifer!

  • Report this Comment On April 15, 2010, at 8:41 AM, TMFAleph1 wrote:

    Great article, Jennifer. On this topic, Mather is a first-rate interview subject. Thanks!

  • Report this Comment On October 18, 2010, at 7:48 AM, jadesmith123 wrote:

    Understanding European debt crisis can doubtlessly be a tricky thing, but the key to understanding exactly where things went wrong lies in making a note of several macroeconomic movements that unfolded in this region over the course of a decade. In the end, the economics just don’t add up. Without tax breaks and government subsidies, not a single alternative energy will be able to compete. So no matter how popular or fashionable alternative energy becomes, if it remains economically stupid, it’s destined to fail.

    http://www.financemetrics.com/2010-european-debt-crisis

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