The Return of the Sovereign Debt Crisis

The US stock market continued whistling past the graveyard yesterday, as the Dow Jones Industrial Average added 33 points to 12,427 – its highest closing level in nearly three years.

Sure, the US economy is showing signs of life, but these signs seem like mere weeds atop a mass grave of government stimulus efforts. Even from a distance – say, from wherever you may be to Washington, DC – you can almost smell the rotting of government finances.

The stench is unavoidable. The smell of dying welfare states fills the air, whether you be in Athens, Sacramento, Tokyo or Lisbon. As the weakest of welfare states drifts off toward that “dark night,” the world’s equity markets seem not to care.

The looming threats of a government shutdown here at home and/or a Portuguese default over in Europe are mere footnotes alongside an “upside earnings surprise” at Bed, Bath and Beyond…at least for now.

But investors do well to remember that dying enterprises – and the fatally flawed securities they issue – do not degrade in an instant. Decomposition takes time…sometimes much longer than most folks would imagine.

A little over one year ago, your California editor speculated that the Greek debt crisis of early 2010 would become a much larger phenomenon that would play out very much like the subprime-cum-Lehman-Bros.-cum-national crisis of 2007 and 2008.

In a speech early last year, he remarked, “Everyone thinks Greece will pull out of its mess with austerity measures and German bailouts. I’m not so sure about either assumption…

“Greece’s finances are not unique; they are emblematic. Sovereign borrowers are out of control. Greece is just an icon for all of Europe, and also the US.

“So I view Greece as the Bear Stearns of the upcoming sovereign debt crisis. You may recall that in June, 2007, Bear Stearns stepped in to bail out two of its own hedge funds by pledging collateral for a $3.2 billion loan.

“Nine months later, in March, 2008, JP Morgan Chase took over a functionally bankrupt Bear. And at that point most of the official Wall Street elite believed that the crisis had been averted.

“But six months later, on September 15, 2008, Lehman Bros. filed for bankruptcy. And the rest is history. It is amazing to remember that 15 months elapsed between the first [overt] signs of difficulty in the US financial sector and Lehman’s bankruptcy. So mark your calendars; the Sovereign debt crisis should unfurl by May 2011 – that would be about 15 months after the initial headlines about Greece.”

Thus far, your editor’s prediction seems largely misguided. After roughly 14 months into this potential crisis, there isn’t one. Most European equity markets are buoyant and the euro hovers near a 15-month high against the dollar.

“Portugal’s request for a bailout could mark the moment that Europe finally contained its debt crisis,” the Associated Press triumphantly proclaimed this morning. “Unlike previous bailout requests, Portugal’s has not been greeted by a chorus of concern in financial markets over which country will be next.”

Despite this seeming calm, your editor is not prepared to abandon his “crisis timeline” just yet. Some intriguing parallels are developing between the current troubles in Europe and the US crisis of 2008.

For starters, note the strikingly similar trajectory of the Portuguese 5-year credit default swaps during the last 14 months compared to the Goldman Sachs 5-year credit default swaps from early 2007 through September 2008. [Simply stated, credit default swaps are “default insurance.” Hence, their prices rise as the prospect of a default rises].

5-Year CDS on Portuguese Government Debt vs. 5-Year CDS on Goldman Sachs Debt

Both the Portuguese and Goldman CDS prices trended jaggedly upwards, reflecting increased anxiety, but no panic. Then, in the case of Goldman Sachs, anxiety became panic overnight, on the days following the Lehman bankruptcy.

Perhaps a similar fate is in store for the sovereign debt markets of Europe…and for the euro itself.

“Given how the crisis has unfolded over the course of the last few years, we struggle to see that the activation of help for Portugal will mark the end of contagion,” says Nick Matthews, senior European economist at the Royal Bank of Scotland. “We therefore remain of the view that countries with high private and sovereign debt will remain at the mercy of further loss in market confidence.”


Despite the so-called containment of the Portuguese government’s insolvency, Portuguese banks publicly refused yesterday to purchase any additional government bonds. Meanwhile, no one anywhere on the European continent can say what size or structure of bailout Portugal may or may not receive.

And even after receiving a lifeline, Portugal would still face capital markets that will demand usurious rates of interest to provide any capital whatsoever. This story is not over, folks.

Widespread sovereign insolvency, combined with the stench of decaying government finances, may not be immediately bearish for the financial markets, but we doubt they are bullish.

Eric Fry
for The Daily Reckoning