Not the End of the Greek Sovereign Debt Crisis


The Aussie market has opened down. But for the first time since September of 2008, the Dow Jones Industrials have closed over 11,000. All hail the coming of the new bull!

You could surmise that the catalyst for higher share prices – since it isn’t earnings or the economy or insider buying – has to be the Greek deal/bailout announced on Sunday. That plans sounds a lot like the plan to exit an airplane, “in the event of a water landing.” Until Sully Sullenberger landed his plane in the Hudson last year, we’d always assumed “a water landing” meant a smash into the ocean and instant death.

But the Greeks have avoided a flat spin into debt default for now. Europe’s wise old men and women agreed to a US$61 billion rescue plan that makes $43 billion in loans available to Greece at 5% interest if private capital markets do not participate in Greek bond auctions. Call in the Trichet put.

This does not end the sovereign debt crisis. It only takes us to the next stage. And we have quite a bit to say on that stage. But for now, we’re still finishing a bit of research on it so we won’t dive into it in today’s episode.

How about a brief epilogue to yesterday’s discussion of housing? More buyers are needed to send over the wire and into the auctions. But where will they come from? Despite the high clearance rates nationwide, Peter Martin reports in today’s Age that buyers are actually deserting the property market. Maybe they got what they came for. Or maybe it’s too expensive. Or maybe they can’t get credit.

According to data from the Australian Bureau of Statistics, the number of home loans made in New South Wales is down 27% from September of 2009. The decline was 29% in South Australia, 25% in Queensland and Tasmania, 16% in Western Australia, and just 12% in booming Victoria. “This will lead to a slowing of price growth, no question about it,” says David Airey, president of the Real Estate Institute.

Hmm. Do you reckon the Real Estate Institute is trying to bluff the RBA into not raising interest rates any longer? This might allow the banks to keep lending. But the banks are actually lowering their loan-to-value ratios. Requiring a larger deposit shores up the balance sheet. But when UK banks tried to address their overexposure to residential real estate by lowering LVRs, the market “got slammed.”

This is exactly what we were thinking last night over a cheese-drenched veal parma (without the ham), reading Dr. Marc Faber’s latest Gloom, Boom, and Doom Report. “I think it’s fair to say that every asset bubble makes people feel temporarily rich, because on the back of rising asset price the owners of assets can increase their borrowings or trade out of their inflated assets and consume more than is possible of no asset bubble had taken place.”

To wit, this article from last week’s Sydney Morning Herald suggests that Australians are refinancing their homes (at lower rates and higher prices) and withdrawing equity (when they have it) to finance the purchase of big ticket items. Not only is your home your castle, it’s also an ATM.

This is just what Dr. Faber is talking about. “In an asset bubble, people can consume today out of borrowings and capital gains what, in a non-inflationary environment they would have consumed through accumulated savings. Simply put, asset bubbles ‘frontload’ consumption at the expense of consumption when the bubble bursts.”

If they could understand it, this would not be welcome news to government ministers. It means that by “bringing forward” housing demand to prop up prices (via the First Buyer’s Grant, the relaxation of foreign investment in property, and the buying of securitised loans by the AOFM) they have ignited a super spike in Aussie house prices. And not only are house more unaffordable than ever, the paper gains have encouraged people to refinance and borrow against their home to support new consumption.

When you have unsound money and unsound money management, you get a debt-laden disaster. You can’t really blame politicians for suckering Australians into new debt at precisely the point where interest rates were/are making historic lows. Politics is all about “time preferences” too. They’re called elections. And if you haven’t made people feel richer by the time they come around, your time may be up.

This is why H.L. Mencken called elections “an advance auction of stolen goods.”

But the moral hazard of shifting time preferences for savers and investors – which is what you do when you manipulate the price of money and distort markets by throwing money at them – is that you cause otherwise prudent people to make really bad economic decisions. Low interest rates and government handouts shift time preferences forward. Or, in laymen’s terms, they cause people (and a nation) to be short-term focused (or financially short sighted).

It’s fun while it lasts but it won’t last forever. And at heart, you have to acknowledge that the origin of rising Australian prices is not immigration, tight supply, or some bogus shortage. It’s a credit bubble. As Dr. Faber writes, “Every asset bubble was caused and accompanied by easy money and a rapid expansion of credit. Rising asset prices reinforce credit growth as investors leverage up.”

Nearly everywhere else in the world, investors and households have deleveraged. But as Dr. Steve Keen recently pointed out, Australians – encouraged by their government and the real estate industry – have taken the seemingly benign GFC as a reason to releverage. Private debt to GDP levels have risen.

Or, in his own words, “Australia has avoided the GFC by recreating the conditions that led to it. Needless to say, this is not entirely a good thing. We are potentially avoiding pain now by setting ourselves up for greater pain in the near future.”

But how soon is that future? Is it now? Or now? Or now?

One key is whether the faux resolution of the Greek crisis will lead to rising sovereign bond yields. This might seem counterintuitive. If Greece is less risky and volatile, shouldn’t bond yields fall? Maybe not. If investors think the sovereign debt crisis is over, they may shift out of supposedly risk-averse assets like bonds and into equities. This would argue – in the very short term – for higher highs on the indices.

But rising government bond yields cause a world of hurt, too. First off, it makes it more expensive for governments to borrow. Perhaps this is why Pimco bond chief Bill Gross is selling U.S. Treasuries. He’s not worried about deflation at all. He’s worried about rising rates and inflation.

You should read his full note if you have the time. But the short version is that, “high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly.”

One more note of caution. U.S. and U.K. banks increased their holdings of government bonds during the GFC as a way of improving the asset side of the balance sheet with more, ahem, credit worthy assets. That could be a problem if bond yields spike (and prices fall). In other words, for the Atlantic economies, the next phase of the crisis might come from falling bond prices affecting the solvency of banks.

And Australian banks? They remain uniquely exposed to residential home prices. And they remain uniquely dependent on funding expanded lending through wholesale borrowing overseas. To the extent that rising sovereign bond yields mean higher borrowing costs globally, Aussie banks will face higher funding costs. You’d imagine that would lead to higher home loan rates here, which, needless to say, would not be good for the housing market.

Not that the banks are going to just come out and tell you there’s a problem. According to today’s Wall Street Journal, “Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York.” Hmmn.

A group of 18 banks – which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc. – understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.”

We won’t go into the details of the trick here. But the takeaway is that everyone thought the banks had deleveraged in the last two years. But perhaps that is not the case. And perhaps banks are still using short term lending to boost collateral, which allows for more borrowing and more speculating…on things like higher stock prices, commodity prices, or the collapse of Greek debt. Now wouldn’t that be interesting?

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

Leave a Reply

Be the First to Comment!

Notify of

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to