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January 2021
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Are we prepared for the next financial crisis?

A discussion at Chicago Booth:

Europe’s debt disease

The following graph was taken out from a recent report on Europe’s debt trajectory by GMO’s Rich Mattione. It pretty much summarizes the current dire situation in Europe.

Greece is not the only country in trouble.  Italy is the real threat to the stability of Europe. If Italy falls, Europe falls.

Germany and France, the two largest economies in Europe, are relatively better positioned, but their government-debt-to-GDP ratios, 83% and 82%, respectively, will seriously constrain their ability to bail out the PIIGS (Portugal, Italy, Ireland, Greece and Spain).  In contrast, Scandinavian countries enjoy the strongest position in all developed countries, with the debt-to-GDP ratio well below 50%.

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Who owns Greek debt?

Greece has total debts of €346.4bn. About a third of this debt is in public hands (34.8% is attributable to the IMF, ECB and European governments), roughly another third is in Greek hands (28.8%, essentially for banks) with the remainder (36.4%) held by non-Greek private investors.

 

The impact of a US debt downgrade

Friday’s downgrade by S&P of the US sovereign debt, from AAA to AA+, was an extraordinary event in modern finance.  As reported by WSJ, the is the first time the US government debt lost its AAA credit rating in more than 70 years.

What does this mean for the US and world economy?  Here is an insightful interview of Nouriel Roubini (aka Dr. Doom), Christina Romer (former Chairman of President’s Council of Economic Advisors), and Jim Bianco (president of Bianco Research).

 

US Treasurys are widely held as collateral by many financial institutions around the world.  The biggest risk is a sharp fall in value of US Treasurys may trigger another credit dry-up in the financial system.  This is perfectly summarized in the following paragraphs in the WSJ piece:

J.P. Morgan Chase & Co. analysts estimate some $4 trillion worth of Treasurys are pledged as collateral by borrowers such as banks and derivatives traders. If that collateral isn’t considered as high quality by lenders, the borrowers could be required to cough up more cash or securities to put the minds of lenders at ease.

That could force investors to sell off other assets to come up with the money. In a worst case scenario, credit markets could seize up, as they did during the Lehman Crisis.

Money market funds held by millions of Americans hold some $1.3 trillion in securities directly or indirectly exposed to Treasury and government agency securities, as well as short-term loans to financial institutions, known as repos, which are backed by Treasurys. Experts say that the downgrade won’t force money market funds to sell. But there are still risks.

If Treasurys tumble in value, funds will be forced to mark down their holdings, raising the potential for some to “break the buck” as the Reserve Primary fund did during the worst of the financial crisis.

 

Lastly, let’s hope China and Japan won’t sell: a key concern will be whether the appetite for U.S. debt might change among foreign investors, in particular China, the world’s largest foreign holder of U.S. Treasurys. In 1945, foreigners owned just 1% of U.S. Treasurys; today they own a record high 46%, according to research done by Bank of America Merrill Lynch.

In theory, China and the US are on the same boat: a fall in US Treasurys won’t do Chinese any good.  But that’s only theory on paper: people do all kinds of things when they panic.  Same thing applies to governments.   Personally, I think the chance is very slim for Chinese to dump US Treasurys.  But always be reminded “what could happen” – Re-watching this 2009 interview of Julian Robertson of Tiger Management will help you appreciate the worst scenario.

Eurozone’s debt contagion

Interview of Harvard professor Nail Ferguson. Will Germany-France bail out Greece, Spain and Portugal?

Remember Milton Friedman’s prediction — “Euro can’t survive a major crisis.” Let’s watch and see.

(update 1) Rolfe Winkler writes on Reuters on the same issue. He outlined three possible outcomes.

1) The PIIGS (acronym for Portugal, Ireland, Italy, Greece and Spain) cut their budgets to pay back debt. Such austerity programs are typically very difficult to get done in democracies. Deficit spending stays high long past the point that it’s possible to work off debt over any reasonable period. To successfully dig out of the hole requires cuts so deep, voters never agree to them.

2) Europe bails them out, which is the easiest solution in the short-run. Richer European countries certainly have the wherewithal to bail out a small country like Greece or Portugal. But it’s a dangerous precedent to set. What about Spain? It’s 14% of the Euro economy compared to 6% for Portugal/Ireland/Greece combined. If economies keep spending with an eye towards a bailout from the ECB, eventually you get #3.

3) The monetary union breaks apart. The customary way out of a debt crisis is to devalue one’s currency, see Argentina in 2001. It couldn’t maintain it’s dollar peg and still service its debt, so it devalued its currency and defaulted on debt. But this locked the country out of the international capital markets and drove them into a deep, though brief, Depression. For Greece to devalue, it would have to pull out of the Euro, pass a law that it’s debts are payable in new local currency and then devalue.

Paulson: the US was very close to financial collapse

Paulson’s interview with Bloomberg.

At one point, he talked to his wife, Wendy, on the cell phone, “I am scared…pray for me.”

Also watch my previous post on Inside the Meltdown from Frontline.

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Ring of Fire

From Bond King, Bill Gross:

(click to enlarge)

The most vulnerable countries in 2010 are shown in the chart “The Ring of Fire.” These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth.