This is the continuation of a 10 part blog series entitled, “10 MACRO HEADWINDS IN THE FACE OF INVESTORS.”
We all should know what a bond is. A bond is a security where one party is lending to another creating a financial obligation to repay the debt. Here’s a little harder term, “CDS.” A CDS is a collateralized debt security. A CDS is a financial derivative contract. That sounds complicated and fancy-schmancy and it is in many regards. But let’s boil a CDS down into plain English.
If an investor (whether that is a bank, a pension fund or an individual investor) buys a bond, they often can buy insurance on that bond. Why would they do that? They would do that to protect against the possibility of the borrower not paying the debt back. Then the lender is screwed out of the money by lending to a bum who skips town on the loan.
Let’s apply it in real terms. A country wants to borrow money, say Greece. And investors are interested in lending money to Greece to earn a rate of return (in the form of interest payments). And the investors want assurance that they will be able to collect the loan from Greece. They do this in two ways; first, doing analysis to gain assurance that Greece will have the money to pay it back and second, buying an insurance policy in case Greece can’t pay it back (the CDS contract).
So now years go by and investors keep lending money to Greece. They lend Greece billions and billions and along the way, people stop doing good analysis in determining if Greece is borrowing too much money (sort of like certain mortgage companies and credit card companies with individuals here in the United States). Pretty soon, Greece is spending money like mad on benefits, retirement programs, social programs and projects. The money is going out faster than it is coming in and future promises are building and building.
Eventually the debt becomes so large that investors come to the conclusion that Greece isn’t going to be able to pay the money back. “No worries,” some investors think because they bought a CDS contract insurance against this risk. But buried in the fine print the language states that if the bond is restructured “voluntarily” then the CDS contract is no longer enforceable. And the European Union, who realizes that Greece can’t pay the money back but also realizes that the banks will explode if they are forced to take the losses and pay out on the CDS contracts forces lenders to “voluntarily” restructure the loans and write off 50% of the face value. CDS holders are now screwed over. They are prevented from collected on the insurance. So they ended up paying for insurance that will never be collected even though Greece couldn’t pay the money back.
And so the European Union now has to deal with unintended consequences. Since there are plenty of other countries who are over-leveraged with massive amounts of debt, investors now believe that the CDS contracts can also be deemed worthless if bondholders are forced to “voluntarily” restructure and take a loss on the bonds. Keep in mind, this is like someone pulling a gun on you, demanding taking your money and then deeming the action “voluntary” by the victim. There really is nothing voluntary about taking a large restructuring loss on a bond of this nature.
So now we have bond holders who own billions of Euro’s worth of Italy, Portugal, Spain, Ireland, and Greece bonds that no longer will believe that their CDS contracts will pay off if the bonds won’t be repaid by dead-beat loser countries that acted irresponsibly with borrowed money. What would you do in their shoes? Well, you would either sell the bonds before they become worthless or drop in value or demand a much higher interest rate to offset the real risk of default.
And so we saw this “unintended consequence” happen with Italy this past week. Investors are coming to the conclusion that the financially reckless Italians may not be able to pay the money back. So they began selling the bonds or demanding a higher interest rate to offset the higher risk of default. And we saw the interest rates for 2, 5 and 10 year Italian bonds climb quite quickly.
It creates a death spiral. If the country has a deficit and needs to borrow money to meet their budget, they must pay higher and higher interest rates to meet their financial obligations. The higher the interest rate, the higher their interest expense goes up. Interest expense keeps climbing even though their revenues are staying constant or possibly shrinking. Eventually the debt implodes on them and they default because they can’t keep up with the increasing interest payments.
Individuals get themselves into this same predicament. They start out with good credit and can borrow a little money with a low interest rate since they are a low risk borrower. As they increase their debt, lenders deem the chances of default higher and charge higher rates. Soon the individual is obligated to pay so much in interest expense that they can no longer afford to pay down the principal on the loan. Bankruptcy soon
follows.
As we move forward into the end of 2011 and 2012, we are seeing countries that may end up getting caught in a debt death spiral triggered by the fact that the European Union leaders forced the Greek bonds to be restructured, “voluntarily.” By deeming the restructuring and write-off of bad Greek loans voluntary, they diminished or eliminated the value of the CDS market. What good is paying for insurance if it won’t
be paid? And by doing this, it will drive interest rates up on countries that can’t afford higher interest rates (like Portugal, Ireland, Italy, Greece and Spain).
Where they actually thought they were preventing further financial damage to irresponsible countries, the EU is tightening the screws on the very system they are trying to manipulate.
Investors need to be aware that governments (whether in the EU or domestically) aren’t very good at understanding the concept of “unintended consequences” when they start messing with things that they can’t comprehend. We often think that the
government knows what they are doing and will make things better.
The CDS market woes caused by government officials may end up expediting the demise of the irresponsible institutions that they are trying to protect. Go figure.
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