Sovereign Debt Defaults the Next Shoe to Drop?

Posted by Mike Larsen

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Governments the world over have spent the past year bailing out, backstopping, insuring, and stimulating their financial sectors and economies. Trillions of dollars, euros, yen, and pounds have been thrown around like Halloween candy. Officials have assured us there’s little risk to that strategy.

But we have warned consistently that the opposite is true. Our stance: If you borrow and spend too much, all you’re going to do is transform a Wall Street debt crisis into a Washington debt crisis.

Lo and behold, the bill for all this global fiscal and monetary largesse is beginning to come due. Debt and deficit problems are going from bad to worse in many nations. That’s raising the very real risk of the unthinkable: Widespread SOVEREIGN debt defaults!

Dubai Debt Proves Too Hot to Handle

The first shot across the bow came during Thanksgiving week. That’s when the tiny emirate of Dubai dropped a bombshell on the markets. A government-backed holding company, Dubai World, warned that it needed to restructure its debts. The firm is buried under $26 billion of obligations tied to its property development arm Nakheel PJSC and other subsidiaries.

The United Arab Emirates tried to assuage market concerns by pledging some aid to regional financial institutions. Many investors were also initially reluctant to sell their regional holdings because they believed Dubai’s oil-rich neighbor Abu Dhabi would step in and bail Dubai out.

But that optimism is rapidly fading. The prices of bonds issued by Nakheel, as well as other Dubai-backed companies like DIFC Investments and Dubai Holdings Commercial, are dropping fast. I’m seeing quotes as low as 44.5 and 47 cents on the dollar for some of them. Moody’s added to the concerns by downgrading the debt of several Dubai firms.

Even more troubling: The cost of credit default swaps — a form of bond insurance — on Dubai’s own OFFICIAL government debt is exploding. It just surged to 545 basis points from a pre-crisis level of around 257 basis points. That means it now costs $545,000 a year to insure $10 million of Dubai debt against default, more than twice as much as a few months ago.

Am I surprised? Not in the least. I mean, look at what Dubai has done in the past few years. It built an indoor ski slope in the middle of the desert. It constructed palm-shaped islands in the Persian Gulf, loaded up with overvalued property. And it borrowed hundreds of millions of dollars to build the tallest tower in the world, the Burj Dubai.

In other words, the Dubai debt crisis was a long time coming. But the troubling thing is that Dubai is NOT alone …

Greece Heading down the Slippery Slope to Default?

Greece is part of the European Union, and it’s rapidly sliding down the slope toward default. Its budget deficit has exploded to 12.7 percent of GDP, the worst in the 27 EU countries, while its outstanding public debt load is on track to hit 125 percent of GDP next year.

In order to avoid stiff EU sanctions and penalties, Greece is slashing its operations budget by 10 percent. The government is also planning a 2010 hiring lockdown and a partial public salary freeze. Greece’s Finance Minister George Papaconstantinou says there is “absolutely” no default risk.

But those measures don’t appear to be comforting investors. The Athens Stock Exchange General Index has plunged more than 28 percent from its mid-October high. Meanwhile, Greece’s two-year government debt just dropped in price by the most in 11 years. Yields on those securities have more than doubled to 2.97 percent from 1.32 percent in less than a month!

Fitch has already cut Greece’s sovereign debt rating to “BBB+.” That’s the third-lowest investment grade rating. Standard & Poor’s rates Greece “A-,” but that rating may be lowered soon.

Bottom line: We’re facing the very real possibility of a significant sovereign debt default or bailout in Europe.

What about Spain? The U.K.? The U.S.?

At times like these, investors naturally ask themselves where the next domino might fall. My answer: How about Spain? S&P just lowered its credit outlook for that country to negative from stable. The ratings agency cited “pronounced deterioration” in the country’s public finances.

Spain is in trouble because it experienced its own gigantic housing bubble, one that has long-since popped. Unemployment is on track to top 20 percent in 2010, while the nation’s deficit is swelling toward 11 percent of GDP. The economy has shrunk for six straight quarters, prompting the government to spend billions of dollars to stimulate growth.

Then there’s the U.K. Its budget deficit is running at 12 percent of GDP, the highest in the Group of 20 community of nations. That’s forcing the government to impose a 50 percent tax on banker bonuses, and to boost income taxes. Despite those moves, the U.K. Treasury is still going to have to borrow billions more pounds than it originally planned to fund its deficit.

And what about us? The fiscal 2009 budget deficit here soared to $1.4 trillion, the worst ever. That was equal to 9.9 percent of the overall economy — almost triple the level of a few years ago and the highest in the nation’s history, excluding years where deficits were bloated by massive war spending (à la World War II). Over the next decade, the Congressional Budget Office projects an additional $7.2 trillion-plus in red ink.

We are now borrowing record amounts of money, week in and week out, to underwrite our profligacy. Example: In the week of Thanksgiving alone, the U.S. was forced to sell a whopping $118 BILLION in debt. That included $44 billion in two-year Treasury notes, $42 billion in five-year notes, and $32 billion in seven-year notes — all record amounts for any single auction.

Our debt load is rising so fast, Congress will soon need to raise the so-called debt “ceiling.” The current $12.1 trillion limit could reportedly jump by as much as $1.8 trillion.

Everyone knows the cap is a joke. Every time we come close to tagging it, lawmakers just raise it again. But the frequency and size of those increases is getting totally out of control.

Indeed, we may be seeing the first signs of a bond investor rebellion. Yesterday’s auction of $13 billion in 30-year bonds bombed big time. The Treasury could only sell the debt by offering much higher-than-expected yields, and even at those elevated yields, key measures of demand were weak.

Result: A key interest rate spread — the difference between yields on 2-year notes and 30-year bonds — blew out to 372 basis points. That’s the highest in 29 years of record keeping.

The loud and clear message from the bond market? We’ll buy very short-term Treasuries six ways ’til Sunday. But if you want to borrow long-term money at the same time you’re printing dollars like crazy and selling the most bonds in the history of the world, you’re going to have to pay up!

Nobody expects the U.K. or U.S. to lose their AAA debt ratings anytime soon. But Moody’s just warned in a report that both countries’ ratings are at more risk than those in other triple-A rated countries like Germany and France. And I don’t see any credible plan coming out of Washington to get our disastrous budget situation under control.

Given this environment, my advice for investors is simple: Avoid investing in regions where sovereign credit risk is rising. Focus instead on countries where government debt and deficits are NOT a major threat. For instance, China, Brazil, and Australia are generally sitting on massive reserves, seeing healthy growth, and otherwise prospering even as Greece, Dubai, and Spain struggle.

You may also want to think about lightening up your risk a little bit. That’s what I’ve been doing in some of my services, as my paying subscribers know.

Until next time,


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