by David Kotok, Cumberland Advisors Market Commentary February 10, 2010
Tonight on Larry Kudlow’s show I listened to a gang of four first bash Greece, then the ECB and then the EU. They forecast the demise of the euro and the collapse of the EU. I couldn’t disagree more. Today I had to explain to a good friend and client why all $2.8 trillion of US state and local government debt wasn’t going to default. Today the FT said “Connecticut’s Lisbon, New York’s Rome, Georgia’s and Iowa’s Madrid may lack the sense of budgetary crisis being felt lately in their European namesakes, but America’s states and municipalities could yet spark equally vexing problems for the United States. Like the eurozone’s members, America’s states have no currencies of their own to devalue and must tread cautiously between entrenched public sector unions and irate taxpaying voters.” We are witnessing much hyperbole about a crisis of confidence in sovereign debt. We’ve written about it for months. In our view, crises present opportunity. We will continue the dialogue about Greece below. In addition, we can report that our separately managed Muni accounts are full invested in tax-free bonds and in taxable municipal Build America Bonds. We expect that our clients will be fully paid and are amply rewarded for taking the risk of selected sovereign debt. More on Greece below.
Things are getting clearer regarding Greece. The unions are out in the street, as we expected. The Greek government has committed itself to advance the austerity measures in spite of the strikes. political organizations are holding much discussion but not committing hard money. So far, so good.
The next test will soon come for the European Central Bank (ECB) and here is where the rubber meets the road. Greece will have to roll over some large proportion of its debt within the next few months. Credit-rating agencies have said they need to see Greece adopt an austerity budget and implement it or they will cut the sovereign rating. They mean it and Greek officials know it.
This brings us to the issue of “rollover risk.”
Rollover risk is the term that applies to governments when they have to refinance. Governments are going concerns. They do not liquidate in a bankruptcy. They perpetually refinance their debt. When governments issue debt over the longer term, like 10 or 30 years, they reduce their rollover risk. That is because only a small portion of the debt is coming due at any one time.
But longer-term debt is usually more expensive than shorter-term debt, because the interest rate that the government must pay is usually higher when the debt is longer term. So governments tend to choose shorter-term debt in an effort to lower cost, and then they “roll” the short term debt over and over. The United States is doing that as this is written, and the amounts involved are measured in the trillions. Greece did it and got away with it, for a while.
Some governments are forced to issue only short-term debt, because markets do not trust them. This is usually true of inflation-prone governments. Italy is a good example. Before the euro zone was created, the Italian government had a history of devaluation of its currency. It cheapened the lira whenever it got into economic trouble. It also had a history of high inflation. The did not trust the Italian governments – and there were many of them in succession. Italy reached the point where it had to roll over nearly its entire issuance of within a single year. And the debt burden was about 100% of the Italian GDP. That is an example of an extreme in rollover risk.
This was in the 1990s and during the formative period of the euro and before the euro actually became a currency, but after the Maastricht Treaty was signed in 1991. In that period the interest rate on Italian longer-term bonds was five full percentage points higher than that on the benchmark German bonds. 500 basis points was the spread between Italy and Germany on ten-year .
After the euro was fully launched, those rates converged and Italy at one point traded within a few basis points of Germany. Even today, with all the market turbulence, the Italian spread is still much, much lower than it was prior to the euro. Even Greece today is lower by several hundred basis points than its spread was prior to the euro.
What I have just written is well-known and understood in Europe; the memories of the inflation-prone period are fresh. Therefore those countries and governments are not about to go back to the former structure, which was very costly. Let’s assume that is the case.
The risk now ahead is the rollover. Will Greece be able to do it? Will they go to an auction and find that the bids received are not sufficient to cover the issue?
Here is where the ECB can step in and assist if, and only if, the Greek government has put the austerity budget in place. The ECB can finance the assistance needed to accomplish the rollover. Its method is to accept the Greek debt as collateral and to loan to the banks that are buying the debt. The banks will be at risk to a Greek default. The ECB will be at risk if the banks fail. The ECB will likely proceed as long as the credit rating on Greek debt is acceptable under the ECB rules. Thus the ECB can provide the financing so that the debt issue doesn’t experience a failed auction.
We expect this scenario to play out. That means Greece will reach a point where it can refinance, and the market will price in a premium for all the aggravation, but it will not experience a failed financing. The ECB will have held the high ground so that it will be able to maintain the strong and hard money characteristic of the euro as a reliable world reserve currency. We discussed this issue with Steve Liesman this morning on CNBC. See cnbc.com for the tape.
The weakness of the euro combined with the shock experience in European markets is setting things up for a good buying opportunity. It is too soon to do it now, but one must get prepared. Investors will be able to buy fine German companies and do so when the euro has been weakened by the events originating in Greece. European exporters are for sale cheap while their currency is weak. They will be strong competitors for US companies as they sell to Chinese and other emerging market buyers. That can be a real bargain for an investor.
Adversity is the source of opportunity in investing. Rollover risk is the issue for Greece. It will be resolved before the summer equinox ushers in the bright sunshine that warms the Adriatic. Cruise in the Greek Isles anyone?