Will Sovereign Debt Default be the Primary Cause of the Next Economic Crisis?

Dear Friends,

I know that the Dow is up 191 points, to 10,099.75 as I email this (2.42am), which, on the surface, would seem to negate my gloomy outlook for the stock market and the US economy, but I am looking at the longer term strategic picture, rather than the day to day market swings. The bears are just starting to make their moves, while the bulls are still very optimistic, and thus, we have to give the market time, before our analysis comes true.

This is the reason why, we should not take Short trades at this early time of the downtrend, unless it is a trade for a very short timeframe. Bear traps are aplenty in the early phase of a downtrend. If anything, you may want to take advantage of this bullish upturn to get out on some of your Long Positions, if you still have them. From a technical analysis perspective, there is still no reason to enter a Long Position even with tonight's bullish move. Of course, this is just my opinion, and you have to take responsibility for your own investment / trading decisions. Ok, let's get down to business.

RISE IN CREDIT DEFAULT SWAP SPREADS FOR SOVEREIGN DEBT

Lately, the spreads on CDS (Credit Default Swaps) on Sovereign Debt have been rising. In layman's terms, the CDS spread is the insurance premium you pay, for protection against the failure of a nation's debt (Sovereign Debt). Even Australia's Sovereign Debt CDS spread has risen. This is because the Australian Government is highly indebted. For an analysis on Sovereign Debt of key countries like USA, UK, Japan, Australia, Germany, China, New Zealand, Russia and Singapore, please refer to my blog article entitled "Forex Fundamental Analysis 081112" which was written on 12th November 2008. Although a little dated on the statistics, it provides a basic but important overview of the strategic picture the world is grappling with today. Luckily for me, I did my homework, a year in advance of the problems today. :-)

http://praesciens.blogspot.com/2008/11/forex-fundamental-analysis-081112.html

Given the current global concerns over the risk of Sovereign Debt Default, the question we are trying to answer today is, "Will Sovereign Debt be the Primary Cause of the Next Economic Crisis?"

The short answer is "NO".


THE RATIONALE FOR THE ANSWER

Sovereign Debt, no matter how large, is not a phenomenon that just happened overnight. The world, and some of the highly indebted, developed countries have survived this situation for decades. So, why should the current levels of Sovereign Debt be the cause of a debt default crisis today?

The risk and fear of Sovereign Debt Default is the symptom of the root cause, not the cause in itself. If it is the root cause of an economic crisis, such a crisis would have happened long ago. In the end, the Sovereign Debts will not default, albeit a few scary moments and one or two Lehman type of collapse, but on the overall, the majority of the Sovereign Debt will stabilize eventually, no matter how indebted some of these countries are.


THE ROOT CAUSE OF THE NEXT ECONOMIC CRISIS - SHORT ANSWER

What makes me come to this conclusion? If so, what is the root cause of the next economic crisis?

The short answer ..... the artificially Low Interest Rates regime today. It is the fear of world interest rates rising that is causing the demand for Sovereign Debt to slowly dry up. Investors who normally would not blink an eye to invest in Sovereign Debt are now starting to question the Reward / Risk Ratio, and therefore, the wisdom of continued investment in Sovereign Debt, in light that they may stand to lose a lot of money, should world interest rates rise.

Why? Let's look at an example.

When an investor first subscribes for a Greek Government Bond at say, $1 per unit, the Interest Rate, called the coupon rate, is set at say, 4% per annum. However, because investors anticipate that interest rates will rise, the price per unit of the Bond may sell for less than $1, say, $0.90, i.e. the price falls by $0.10. This gives a bond yield of 4.4%, i.e. 4% divided by $0.90. In this way, the market is pricing in a rise of 0.4% in Greek Sovereign Debt Interest Rate, in the foreseeable future. Should investors believe that there is a high risk of default, even such a yield may not be sufficiently attractive for investors to lock in their money, for many years, and thus, the price of the Bond drops even further.

In a nutshell, the price of the Sovereign Bond drops if interest rates are expected to rise, or is rising. In this regard, investors lose money, by holding on to the bonds, and thus, less and less investors are willing to invest in bonds today, be it a Sovereign Bond, or a corporate bond, or a municipal bond. Why? Because the world believes that world interest rates will rise soon.

This lack of desire to invest in bonds is causing demand for bonds to dry up, bit by bit.


BASIC ECONOMICS IN ACTION

If supply of money to invest in Bonds is drying up, because of perceived higher risk of loss, whether through default or through drop in price of bonds invested in, then, there are only two ways that this decrease in supply can be countered, i.e. either

• the demand shrinks proportionately, and the price (Interest Rate) is maintained, or,
• Price (Interest Rate) rises to such a level, to induce higher supply, to cope with existing demand.
  

DEMAND IS INELASTIC -GOVERNMENT BUDGET DEFICITS NEED TO BE FUNDED

The problem is, unlike we mortals, Governments have always over spent, and have never practiced any financial self control / discipline. For example, for the year 2009, the US Government earns US$ 3.8 trillion but spends US$ 5.4 trillion. Thus, the US Government needs to borrow US$1.6 trillion to fund its excess expenditure. This excess expenditure is called Government Budget Deficit Spending.

If you and I were to do such things, we would be declared bankrupt within a few years, if not months, but the Governments of the world have been doing such ridiculous things for centuries now.

What is significant today, is that, like a drug addict, the Governments of the world is forced to continue this Budget Deficit Spending, despite being already highly indebted.

The key is that as long as investors with tons of cash are willing to continue lending money to governments to overspend, such governments can continue to borrow indefinitely. So, the governments never think of repaying, i.e. paying down the debt that is already existing, but instead, they borrow more and more. When a debt comes due, the governments just borrow more, to pay for the principal and the interest due, not unlike what you would do, if you were in financial trouble, and attempted to borrow from one credit card, to pay another credit card debt that has become due. Such an activity is called "Rolling over of debt". Most governments practice "rolling over of debt", and thus, government debts keep mounting.


THE IMPLICATION OF INELASTIC DEMAND DUE TO GOVERNMENT BUDGET DEFICIT SPENDING - HIGHER INTEREST RATE

The above discussion has one important implication. It means that DEMAND for investors' money to subscribe for Sovereign Bond is inelastic, i.e. cannot be changed, whatever the price. To understand the term inelastic, think "electricity" for your home. No matter what the price of electricity is, you will still use it. Similarly, demand for petrol is inelastic. You may cut down slightly on joy rides, but for the most part, irrespective of the price of petrol, you will still buy it.

Whenever there is a significant imbalance in demand and supply, as in the current situation on Sovereign Debt, where investors are starting to shy away from subscribing for Sovereign Debt, and thus, Supply of money is drying up, whilst Demand for money is inelastic, Price (Interest Rate being the price of money) will change (rise) to the extent that this imbalance becomes balanced once more, either because Supply is increased once again, because of the attractive interest rate, or because Demand is decreased as those who cannot afford to pay the high interest rates are squeezed out of the market.

Since we are talking about Sovereign Debt, Demand will not be squeezed out, with some minor exceptions. BUT, Price of Money, i.e. Interest Rate offered by the Governments have to rise.


EVIDENCE SUPPORTING A HIGHER WORLD INTEREST RATE REGIME

The recent stock market fall was sparked by a failed bid by the Portuguese Government to borrow Euro 500 million. Only 2/3 of the Government Bond was subscribed, i.e. around Euro 350 million. This is a small sum of money to raise, and yet, the Portuguese Government could not do it. The financial markets took it as a sign of what is to come, when other Governments of the world try to borrow money, in future. It is not that the world doesn't have the money to lend Portugal Euro 500 million, but rather, it is because the world thinks that the Interest Rate (price of money) offered to investors is too low, given the high risk environment for a loss on bonds today. The Portuguese Government Bond yield is around 4.3% per annum currently.

But, the world is more concerned with the Greek Sovereign Debt. What is the current Government Bond Yield for Greece today? It is around 6.6% per annum today, which is quite high for a Sovereign Debt.

The expected trend for the foreseeable future is that the governments of the world will be competing for investors to lend them money, and this trend is expected to push interest rates up, throughout the world. Thus, the days when the US Federal Reserve can keep its FOMC rate at 0.25%, thus, enabling the US Government Bonds to yield only 2.5%, is almost gone. Sooner or later, and investors are betting on sooner, even the Fed Rate will rise, not by 0.5%, but maybe 1% to 2%.

Imagine a world where Fixed Deposit Rates are up 1% to 2% from current level, and loan rates are up by 3% to 4%.


THE ROOT CAUSE OF THE NEXT ECONOMIC CRISIS - LONG ANSWER

The root cause of the next economic crisis is not Sovereign Debt Defaults. Whilst it is possible and conceivable that there will be two or three countries that will default, (maybe Argentina? But even then, only in conjunction with a currency crisis), the Governments of the world need only raise the Interest Rates they offer, to an attractive level, for investors to continue to lend them, and thus, avoid any debt default crisis.

The problem is, these governments cannot fund their inelastic budget deficit spending without increasing interest rate. This is a unique situation that the world has not experienced since pre-Greenspan era. Alan Greenspan was the Federal Reserve Chairman for the period from 1987 to 2004. He was able to manage the US economy in such a way that he was always in control of the Federal Reserve Interest Rate. Prior to his "reign" at Federal Reserve, there were occasions when countries including the US would go into severe recessions, and then lose control over the Interest Rate mechanism to free market forces.

How do we know that such things happen? Because it is in the interest of every government in the world to keep interest rates low, as long as it doesn't create an excessive asset bubble or high inflationary pressures. Why? Because almost all governments of the world are highly indebted today, and thus, no government wants to pay higher interest rates when it needs to keep borrowing, if it can keep the price of money low.

So, interest rates will always remain low, as long as governments can control it. The only time the governments of the world lose control over interest rate, is when there is an abnormally painful economic crisis, that continues to loom over our heads, like today. Whilst we are assured by the media that an economic recovery is on the way, the people around the world know better, because they are the ones feeling the pain.

So, the only time when governments of the world lose control, is when Supply of Money for Government Bonds shrinks .... like today.

This is what I mean when I said that "The key, the next shoe to drop is the Interest Rate Derivatives", in my blog / email article entitled "Singapore's Economy Shrinks 6.4% in Q4" dated 5th February 2010. I quote -

http://praesciens.blogspot.com/2010/02/singapores-economy-shrinks-68-percent.html

"My point .... no, the world is not falling apart overnight. But, every day, it is getting closer to economic disaster. We don't know exactly when it will happen, but we have a clue in the form of Interest Rates. The Fed has to raise interest rates significantly, at a very fast pace, too fast, and this will catch everyone off guard, and cause massive losses. But the Fed is resisting this move, knowing the next crisis to come, for as long as they can. So, when the Fed does make a move, you know that it is not voluntary in nature."


HOW WILL THE NEXT ECONOMIC CRISIS HAPPEN?

The crisis will come in two parts. First, the imbalance between demand and supply in investor money for bonds will cause the governments of the world, including the Federal Reserve, to lose control over interest rates. Of course, the Fed will give some form of excuse to raise the interest rate, but given the amount of money that the US Government needs to borrow, i.e. US$1.6 trillion per year, in addition to its existing debt of US$14.4 trillion, there is absolutely no reason for the Fed to raise interest rate, unless it has no choice. So, when the Fed raises Interest Rate, you know it has almost lost control, to the free market forces of demand and supply.

This will spark a raising of interest rates throughout the world, to match what the US Government is paying. Thus, world interest rates will rise. When world interest rates rise, this will cause Interest Rate Derivatives spread to widen significantly.

What is this Interest Rate Derivatives? It is made up of many things, but a simplistic understanding would be as follows.

Let's say you borrow money at a certain interest rate, say, 5% per annum. You are satisfied with the cost of borrowing because your business can generate a return on investment of say, 8%, from this money borrowed. However, should the loan interest rate rise, your business profit would be eroded. Thus, you buy insurance with a bank, called an Interest Rate Derivative, so that you fix the loan interest rate at 5%, irrespective of what the prevailing market rate will be in the future.

How can such a simple business strategy turn into an economic crisis, you ask?

Because, the Federal Reserve brought the FOMC rate down to 0.25% per annum in 2008, and loaned the US Banks a trillion dollars, ..... some say, two trillion dollars. The Fed did this to encourage the banks to lend money to spur economic growth in the US.

Borrowing at such low interest rate from the Federal Reserve obviously must be good for the banks, right?

The problem is, the banks did not lend the money out to normal borrowers like consumers or businesses. In fact, if anything, the banks squeezed the consumers and businesses to repay their loans as soon as possible, and curtailed further lending, due to the higher risk environment of debt default.

So, what did the banks do, since they are flushed with cash, not only from the borrowings from the Fed, but also from the loan principal collection?

The banks loaned the money to the US Government. Remember that the US Government needed to borrow US$1.6 trillion a year? The figures jive right? More or less it does.

Why not? After all, if you can borrow at 0.25% per annum and lend to the US Government at 2.25% per annum, why take a risk to lend to Tom, Dick and Harry or XYZ Incorporated?

So what's the problem? Isn't lending to Governments, especially the US Government THE SAFEST loan you can make? After all, the US Government Debt is rated Triple A and the Treasury Secretary, Timothy Geithner, had just recently reiterated that the US Government's triple A rating would stay.

In taking the easy way out, to make easy profits, the banks have committed a basic cardinal sin, that all accountants are taught when taking their accountancy exams ...... never finance a long term investment with a short term debt. For businesses, this translates to ..... never finance the purchase of machineries or land and buildings, with short term debt like bank overdrafts.

Two types of risks arise from such a financing mistake. First, what if interest rates go up? You will then have to pay higher and higher cost of borrowing, but your return on your investment will remain the same. In this case, if the Federal Reserve (FOMC) rate goes up to 2.5% per annum, then, the banks will lose money on the transaction because the Return on Investment is at 2.25%, maximum 2.5%, depending on what instruments they invested in. If the Fed Rate goes up beyond 2.5% p.a., then, the banks will surely lose money, on a long term commitment of between 5 to 10 years.

The second risk stems from a call to return the money loaned. What if the bank withdraws the bank overdraft facility that you used to pay for the machineries? You will have to close down your business because you will not have the cash to repay the bank, and sustain the operations of your business. For businesses, this is the greatest risk, in using short term financing, for long term investments. For the banks, it is possible that the Fed will be more accommodating, and this risk is not as great as in the case of normal businesses.

Given the risk of rising interest rates today, what would you do if you are the CEO of a bank that borrowed money from the Fed at 0.25%, and invested in lending money at 2.25% to the US Government for a tenure of 5 to 10 years?

You cannot unwind the position that you have got the bank into. You can try to sell some of the US Sovereign Debt, but so is everyone trying to do that today. The smarter CEOs bought insurance protection against upward increases in interest rates long time ago. This is called Interest Rate Derivatives .... what we mentioned earlier. Remember?

Here, no matter how smart you are, the risk will always be there. Remember the earlier crisis of the Credit Default Swaps that caused so much arguments over "Mark to Market Accounting", that caused the banks to lose billions of dollars?

At that point in time, some banks bought CDOs (Collaterralized Debt Obligations) i.e. high interest yielding bonds that were risky, but they also bought insurance protection through CDS (Credit Default Swaps), a derivative to protect against failure of payments by the borrowers. But too many borrowers defaulted because the debt was mostly sub-prime and Alt A loans (no documentation evidence loans), and thus, this caused too much losses on the insurers to the extent that Lehman collapsed, amongst the many other financial institutions, whose names have all but disappeared today.

This brings us to the million dollar question. When world interest rates go up, how much losses will the insurers who sold the Interest Rate Derivatives suffer? It is said that the open positions of the Interest Rate Derivatives is around US$140 trillion (US$140,000 billion) today. If the loss is 1%, this would be equivalent to a loss of US$1.4 trillion or US$1,400 billion ..... a lot more than the losses incurred in the Sub-Prime Crisis that started it all.

Which bank has the most Interest Rate Derivatives exposure? Do the banks that have significant exposure have enough capital to pay for the losses? I don't think the current capitalization of all the banks that wrote out the insurance policy on the Interest Rate Derivatives are any where near US$1,400 billion. This means that there will be massive defaults on some very large banks, and here we go again, on a 2nd round of financial and economic crisis, requiring an even bigger government bailout. This is assuming that World Interest Rates rise.

But we have already made a case, in explaining why the demand is inelastic, while supply is drying up, slowly but surely. Is it a sure thing to happen? Is it a Predetermined Element? No. But the probability of it happening is getting higher by the day.

I have explained the disastrous consequences of higher world interest rates from the Derivatives point of view. I have not even mentioned the devastation that a high interest rate regime will do to already cash strapped consumers and businesses, what more, the even more massive retrenchments to come, as a result of further cost cutting measures to cope with higher financing cost. I have also not bothered to complicate the analysis with the potential risk of currency devaluation crisis, which would aggravate matters to an almost inconceivable level of economic disaster.

This is why I say that the KEY, and the root cause of the next economic crisis will be the rising of World Interest Rates. This is why, I say that the Federal Reserve will not raise interest rates, until and unless they have no further option, i.e. they are on the verge of losing control of the situation to free market forces at work. When the world (governments especially) is consuming tons of cash, and supply of cash from investors (not central banks) is stagnant, as is the case today, price, the cost of money in the form of interest rate, has to rise. This is THE RARE HISTORICAL MOMENT in time, when governments of the world lose control over interest rate, the price of money, they have to borrow. This is why it is possible for the Dow to fall to 4,800 +/- 300, as stated in my blog article, "How Low will the Dow Go?"

http://praesciens.blogspot.com/2010/02/how-low-will-dow-go.html

In Malaysia, we experienced such a rare historical moment of uncontrollably high interest rate regime in 1986, when Fixed Deposit rates were at 12%, and bank overdraft rates were at 18% per annum. Federal Reserve Rate went to a high of 12.5% in the late 1970s, just after the Oil Price rose above US$100 per barrel, in 1974. That was when the Fed lost control of the interest rate mechanism, although they will never admit to such a hypothesis. Sounds like history repeating itself doesn't it?

I hope you enjoyed this analysis as much as I did, writing it.

Best wishes,

Ooi