Why You Should Care about Greece

Dwight Johnston
March 10, 2010 | COMMENTS

The sovereign debt woes of Greece dominated the headlines for a week and drove a major flight into the dollar and U.S. treasuries. But the immediacy of the Greek problems faded when the EU ministers came out of a meeting and mumbled a few vague sentences of support for Greece. That seemed to satisfy stock traders, although currency traders are less convinced. Some of you might be wondering why we should care or be concerned about Greece's debt at all. The U.S. economy is at least showing some improvement, although employers still seem reluctant to add jobs. But, if you believe in the economic theory that depleted business inventory restocking will boost hiring and the well-timed hiring of 1.2 million census workers will lead to other economic benefits, you could make a strong case for ignoring Greece altogether.

A quick look at the numbers supports the argument to ignore Greece. The population of Greece is about one-third the population of California. Even more striking, the GDP of Greece is roughly $300 billion compared to California's $1.85 trillion.

So, why Greece?

The reason is that Greece represents tip of the iceberg of a bigger trade. The global leverage trade. The leveraged trade comes in many shape forms and fashions. But for those of you not familiar with these trades, here is a quick and simple example.

If investors owned these Greek debt securities outright, this wouldn't be a huge problem. But, the problem mirrors the mortgage-backed securities problem. These bonds are owned through leverage. As short-term borrowing rates plunged, hedge funds and others borrowed near zero to buy the higher-yielding sovereign securities like Greece. This is a global trade. Those speculators sought the cheapest countries in which to borrow. Those countries would be the U.S. and Japan. As an example, a big euro fund would borrow from a U.S. bank. The fund would then sell the borrowed dollars to buy euros for purchase of the Greek bonds, for instance. What happens is that the fall in the value of the bonds triggers margin calls from the U.S. bank. Now the hedge fund is in the position of liquidating the bonds in an illiquid market or selling other more liquid assets. Additionally, a sharply-rising dollar could mean additional large losses as the funds have to convert euros into dollars to meet margin calls or pay off the borrowing.

Take that one example and multiply the impact around the globe in almost any asset class you can think of. The problems with Greek debt should be taken as seriously as the early warning signs or mortgage-related problems should have been taken here. The contagion threat is not to be likely regarded. As liquidity dries up in bonds like the Greek notes, some funds are forced to liquidate more liquid assets to meet margin calls. As those assets start falling in value, other sales are triggered. Again, this is exactly the way the subprime debacle morphed into the great liquidity squeeze and financial meltdown. Just for good measure, you can also add multiple layers of more complex trades involving derivatives on the various assets like Greek bonds. Remember AIG.

Could “Financial Meltdown Part II” become a reality? Unfortunately, the answer is yes. After the first meltdown, credit spreads soared and margin borrowing of any sort was difficult at best. But as global stock markets rallied, credit spreads contracted again and margin requirements (or haircuts on bonds) fell. The levels aren't quite back to the pre-2008 levels, but they are moving in that direction. How could that happen so soon? Two things enabled this. First, something I call “the power of 0%.” With short-term rates so low and funds more available, leveraged players of all ilks could not resist the siren call of free money and poured into any and all assets. Second, absolutely nothing was done on the regulatory side to prevent this. Yes, some leverage was reduced at U.S. banks, but no firm capital requirements were mandated. Just as important, after all the ranting about consolidating and regulating in some fashion the $600-trillion dollar derivatives market, not one initiative has made it out of the starting gates.

If it weren't for the potential of Financial Meltdown II, we could afford ourselves the luxury of assuming the economic recovery will continue, albeit at a moderate pace. Perhaps we will avoid Financial Meltdown II. But as financial managers we can't lose sight of the reality that problems far from our shores and in markets and esoteric instruments not in our purview have the potential to threaten our economy yet again. This is not to suggest you should make your priority a plan for disaster. But, it would be wise to have in your back pocket a Plan B for just that occurrence.

Dwight Johnston is vice president of economic and market research for WesCorp.