Is the Debt Crisis Over?Submitted by Guidant Planning on March 2nd, 2010
By Allen G. Yee
Just when you thought it was safe to get back in the water new debt issues may be looming. For instance let’s consider sovereign debt. What is sovereign debt? A sovereign bond is a bond issued by a national government. The term usually refers to bonds issued in foreign currencies, while bonds issued by national governments in the country’s own currency are referred to as government bonds. The total amount owed to the holders of the sovereign bonds is what we refer to as sovereign debt. So sovereign debt is essentially the debt a government owes to people outside the country. Herein lays a problem: if a private firm (or person) defaults on a debt you can pursue further action through legal means, however, when a foreign government defaults, there is usually no option for legal recourse.
If a country has debts issued in its own currency (government bonds) such as the US, then if they ever struggled to finance their debt the US could print more money/bonds to inflate away the debt. The problem becomes unavoidable when a country owes money issued in a foreign currency. For example, Latvia issues bonds in Euros. Therefore when the bonds are due for repayment they need to find the currency to pay their debt obligations. They can’t turn on the printing press because they don’t own the Euro press. In fact, no single country owns the Euro because it is the official currency of the European Union (EU) and is currently used in 16 of the 27 Member States.
Recently, Greece has been at the epicenter of the emerging sovereign debt crisis. Concern is growing by investors (and governments) about Greek fiscal imbalances. This wouldn’t be a crisis if it was confined to only one country, but the reality is Portugal, Italy, Greece and Spain (PIGS) are all reeling under crushing government debt. Global investors have little confidence they’ll be able to keep paying them, so their cost of borrowing has gone way up, driving the PIGS into an even deeper hole.
Since U.S. investors tend to avoid foreign government bonds, many will dismiss this as an irrelevant development. That’s a mistake. The reality is that the international implications of this bond-market problem are serious for the world’s stock markets, as well as for the global economy as a whole. There has been talk of default and fear of contagion, as investors question how many more governments have run up bigger bills fighting this recession than they will ever be able to repay.
Just as sovereign debt is becoming problematic, so is municipal debt. All over the U.S., undercapitalized, inefficient cities are looking at an obscure section of the bankruptcy code called Chapter 9. The seldom-used part of U.S. bankruptcy law gives municipalities protection from creditors while developing a plan to pay off debts. Created in the wake of the Great Depression, Chapter 9 is widely considered a last resort and filings under it are more taboo than other parts of bankruptcy code because of the resulting uncertainty for everyone, from municipal employees to bondholders. Potentially, this section of the bankruptcy code could extend to the entire state. This would allow states to renegotiate their legacy pension and union contracts and emerge from bankruptcy a leaner state. Chapter 9 bankruptcies have been filed before, many times. One of the most famousfilings was made by Orange County in 1994.
Some municipalities will be rescued by their state government, others will be selling assets and the remainder will default, sticking it to bondholders who thought municipal bonds were a safe way to earn yield. Think again.
What should you do? Return to basics; Review your values, goals and risk tolerance, assess your current situation, and allow any decision you make to be guided by the results of this process.
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