To Avoid Default, Italy Must Be Bailed Out

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Over the last two years, we've feared that the debt woes of Greece, Ireland, and Portugal would infect the continent's larger economies -- notably France and Italy, the second- and third-largest economies in the eurozone. Unfortunately, as of this morning, the bond market provides strong evidence that at least one of these is a foregone conclusion, as Italian 10-year bond yields rose above the key 7% level on Wednesday.

The bond market as king-maker
For many equity investors -- myself included -- it's almost impossible to appreciate the overwhelming power of the bond market. One person who's not under a similar delusion is Bill Clinton. He feared the bond market's reaction to his 1993 spending plan so much that he abandoned it in favor of a balanced budget after uttering the now-infamous line: "You mean to tell me that the success of the economic program and my reelection hinges on the Federal Reserve and a bunch of [expletive] bond traders?"

A similar thing is now going on in Europe, as rising bond yields have led multiple countries to seek bailouts from the IMF and European Union in exchange for politically destabilizing austerity measures. Over the weekend, for example, Greek Prime Minister George Papandreou stated that he will resign his position as soon as a successor is named. And Italian Prime Minister Silvio Berlusconi pledged yesterday to step down after his country's Parliament approves a series of austerity measures.

The point of no return
The problem that Greece and Italy face is quite simple. Both have inordinately high levels of debt relative to their GDPs. And both continue to run large fiscal deficits, meaning that their governments spend more each year than they receive in revenue. To avoid default, in turn, Greece and Italy must have access to reasonably priced credit via the bond market or they must seek a bailout from outside of their borders -- a measure Greece has already resorted to.

And when does credit become too pricey? Well, if the recent past is any guide, the line in the sand appears to be 7%, for it was at that point when Portugal and Ireland were forced to seek financial bailouts from abroad.

So what does this mean for investors?
If your name is Ayn Rand or Alan Greenspan -- or you otherwise believe in the efficient market hypothesis that current asset prices accurately reflect all available information about future events -- then you should carry on as usual, as the possibility of an Italian default is already priced into the stock market according to this theory. Also, you may be interested in some amazing swamp land that I'm selling in Kansas -- while it isn't as magical as John Galt's hidden valley in Atlas Shrugged, you can't beat the price!

If you're a mere mortal like me, however, and you don't believe in the efficient market hypothesis, there's two ways to play this. For those of you with high risk tolerances, financials like Bank of America (NYSE: BAC  ) , Morgan Stanley (NYSE: MS  ) , and even regional bank Huntington Bancshares (Nasdaq: HBAN  ) have gotten beaten down due in part to fears about Europe, with all three stocks trading at less than book value -- B of A for less than a third! But B of A and Morgan Stanley have said that their exposure isn't big enough to justify those concerns, suggesting that investors are overreacting.

For those of you with low risk tolerances, I suggest taking advantage of the market's current pessimism by locking in high dividend yields. My two favorites in this space are Waste Management (NYSE: WM  ) and Philip Morris (NYSE: PM  ) , with dividend yields of 4.3% and 4.5%, respectively. It's tough to imagine consumers abandoning either of these companies in the near future regardless of how bad things get in Europe or even here at home.

The only thing I would caution against in this regard is chasing dividend yields that appear too good to be true, as they just may be. Annaly Capital Management (NYSE: NLY  ) and Chimera Investment (NYSE: CIM  ) provide two such examples. While these real estate investment trusts pay ridiculous dividend yields of 14.6% and 17.1%, respectively, I've discussed in the past how these yields communicate a risk level that's too high for the average investor.

Looking for more dividend stock suggestions?
Because space is limited here, for more dividend stock suggestions I urge you to check out our recently released free report detailing 11 rock-solid dividend stocks that will help you secure fat quarterly dividend checks this year and in the years to come. I invite you to pick up your free copy today by clicking here now.

Fool contributor John Maxfield, J.D., owns shares of Bank of America. The Motley Fool owns shares of Philip Morris International, Annaly Capital Management, Chimera Investment, Huntington Bancshares, Bank of America, and Waste Management. Motley Fool newsletter services have recommended buying shares of Philip Morris and Waste Management, as well as writing a covered strangle position in Waste Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (11)

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 November 09, 2011, at 1:04 PM, Stocklovr wrote:

    I'll buy the swamp land in Kansas as long as it comes with your crystal ball. Panic and sell, sell, sell never make for good investment decisions.

    If the world ends tomorrow, then it doesn't matter what stocks you own. There is always bad news and panic somewhere in the world. I did very well in March of 2009 when panic in the markets was at it's Zenith because the history of the markets is an upward trend over the long term.

    Over the short term, well, I don't even think about the short term!

  • Report this Comment On November 09, 2011, at 6:29 PM, rfaramir wrote:

    "To Avoid Default, Italy Must Be Bailed Out"

    Then they must default. Bailing them out is out of the question. They are too big to bail out. Many think they are too big to fail, but that just means they will have a big impact when they fail, because they cannot be bailed out. It's not possible.

    So prepare for the default. They will have less access to cheap credit and their citizens will undergo some austerity. Probably not enough of either, unfortunately, but that's due to a weak will and lack of financial knowledge.

  • Report this Comment On November 09, 2011, at 6:33 PM, xetn wrote:

    In the end, they will all default. They can keep printing money and keeping interest rates at zero, but they will still default eventually. It would be better to have let Greece default before all the money was thrown at them. It just made things worse, Now the German, French and other banks, are all too deep now. One default will result in a domino effect.

  • Report this Comment On November 09, 2011, at 6:47 PM, CCharing wrote:

    @ rfaramir

    I think they will be effectively bailout out. Too many sunk costs that the ECB will not allow to be in vain.

    All the world powers want to see it transpire.

  • Report this Comment On November 09, 2011, at 7:01 PM, Zankudo wrote:

    The Italian deficit is about 4% per annum, a lot less than the US. The measures submitted today would bring that down to even in a couple of years. The economy has been growing. The problem is its debt is 120% of its GDP. That also will come down in the near term under the measures undertaken. Half of its debt is held by Italians, and the entire debt is 1.7 trillion, what the US overspends yearly. So, some bond traders raise the interest 46 basis points and the world goes insane. I think it was insane before they did it.

  • Report this Comment On November 09, 2011, at 8:46 PM, CaptainWidget wrote:

    I'll take that Swamp land in Kansas too. If I'm buying it off someone who doesn't understand efficient markets, I have no doubt I'll get a screaming deal.

    The cost of the imminent Italian default is priced into the market, plus the price of the imminent bail-out. Big-Brother has a phenomenal ability to shield us from accurate price signals......

  • Report this Comment On November 09, 2011, at 8:57 PM, NovaB wrote:

    You can't bail out the entire Eurozone.

    Greece is down. Ireland and Portugal are down. Spain is running 21% unemployment.

    Here comes Italy, as big as those four together, and the whole pile starts sliding.

    Heard anything from France lately? last word I got was they were being watched and fretted over the same way Italy was last year. France is the second largest economy in the Eurozone. If they are standing on quicksand, too, there isn't much hope for the whole pile.

    Will it be Great Depression 2.0 or the Greatest Depression?

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