Why Greece Can't Default Just Yet

Greece has been on the verge of defaulting on its debt for more than a year.  Each time the crisis looms its ugly head, European leaders, led by Germany's Chancellor Angela Merkel, come through with another temporary bailout plan that enables the Greeks to survive a little while longer.  But the decision makers about the Greek crisis have to know that Greece at some point is going to default.  So why throw good money after bad with one more bailout? 

The reason is simple: the European market needs to have all its ducks in a row before it allows Greece to default.  If Greece were to default before they are ready, it could potentially have catastrophic financial consequences in Europe and in time to the rest of the world economy.  So while we watch the news showing the Europeans confidently handling the latest debt crisis, behind the scenes they are working as quickly as they can to make the necessary preparations for the eventual default.  It's like watching a duck traveling through water.  Above the surface it looks effortless but below the surface the duck is paddling furiously.  That's what's going on with the European leaders right now.  They are trying to put a "happy face" out to the public to reassure us that they have the crisis under control, but behind the scenes they are all wringing their hands making the hard decisions needed to weather this financial storm.

So what needs to be done to prepare for this eventual default?  Greece has to be kicked out of the eurozone if the euro is to survive, but for that to happen three things must occur: 1) 400 billion euros are needed to firebreak Greece off from the rest of the eurozone; 2) 800 billion euros are needed in order to prevent a wide-scale banking meltdown, because the day that Greece defaults on its debt, there is likely to be banking collapses in Portugal, Spain and France; and 3) the markets will go wild to say the least.  To avoid Italy being dragged down with Greece, it will need 800 billion euros to keep it solvent for the next three years.  So until the Europeans have two trillion euros in funding available for this crisis, they can't kick Greece out of the eurozone. 

So how does this affect commercial real estate in the Pacific Northwest?  For one, interest rates should remain low.  The Europeans will continue to pour their equity into U.S. treasuries (a flight to quality) which will keep treasury rates low.  Secondly, we are fortunate that our trading partners are situated along the Pacific rim.  Most of our exports are shipped to Canada, China, Japan, South Korea and other Asian nations.  If our export volume remains steady the Pacific Northwest should weather this storm without serious consequences.  I am not as bullish about our east coast which trades heavily with Europe.  I believe the Greek crisis will result in slower economic growth in Europe (likely prolonging the European recession) which will have an adverse impact on their buying U.S. exports.  This will eventually affect us on the west coast but not nearly as much as those states who trade significant volumes with Europe.  I still believe that commercial real estate in the Pacific Northwest is a sound long-term investment, and though it may sound like it, I'm not trying to put my own version of a "happy face" on the impact to us of the mounting crisis in Europe.  Stay positive, the world is not coming to an end, we'll get through this. 

Source: Portfolio: Preparing for Greece's Failure, STRATFOR, Peter Zeihan, September 29, 2011.

China to Start Liquidating US Treasuries

Over the past several blog posts, I've focused almost exclusively on the sovereign debt crisis in Europe, and for good reason.  The next jolt to the world economy will likely come from Europe.  How well or should I say how poorly the European Union handles Greece defaulting on its bond obligations will determine the severity of the impact on the world economy.  There are lots of interesting articles on the sovereign debt crisis in Europe that I could write about.  But I'm going to let that situation percolate awhile and instead focus on an obscure article I read recently in the British newspaper, The Telegraph. 

In this article by Ambrose Evans-Pritchard, the head of China's central bank stated that Beijing plans to reduce its portfolio of US bonds as soon as it is safely possible.  At the World Economic Form, Li Daokui, stated that China will in the future be investing more in physical assets.  "We would like to buy stakes in Boeing, Intel, and Apple... Once the US Treasury market stabilizes we can liquidate more of our holdings of Treasuries," he said. 

It is estimated that China owns $2.2 trillion of US debt, and is second only to The Federal Reserve in the amount of US debt owned.  While China accumulated US bonds over the last three decades, The Fed accumulated its bonds in the last couple of years as a result of the Quantitative Easing program, which ended in June of this year. 

China is clearly worried that about the US debt issue, which now exceeds $14 trillion.  Mr. Li described the debt deals this summer on Capitol Hill as "just trying to buy time," saying it will not be enough to stop the growing debt crisis that is mounting.

It's always interesting to see how the rest of the world looks at us in the United States.  So hearing the comments of a Chinese official in a British newspaper about how the U.S. is handling it's debt crisis is like being the proverbial fly on the wall listening into a conversation about your class behavior between your grade school teacher and your mom.  It's interesting to hear what they're thinking but at the same time you know there's going to be consequences.      

So why is this proposed change in China policy important to those of us in the commercial real estate industry in the Pacific Northwest?  Why should we care whether the Chinese are buying more of our debt or conversely liquidating their holdings of US bonds?  BECAUSE U.S. TREASURY RATES ARE DETERMINED BY SUPPLY AND DEMAND!!! 

We now know that both The Federal Reserve and China are planning to stop buying our debt.  So what happens when the top two buyers of our debt are no longer buying?  To make matters worse China intends to liquidate some or all of their holdings of US debt which will only add to the supply of bonds available on the market to be purchased.  Is it conceivable that the rest of the world can purchase their normal market share of US debt plus China's and The Fed's too?  I don't think so.  Logic tells me it's not possible but smarter people than me who are in the know may disagree. 

Assuming I'm correct, then the rest of the world cannot buy the volume of debt we are currently hemorraghing.  What then?  That means over time treasury yields (interest rates) will have to increase in order to entice enough buyers to buy our debt.  If treasury rates go up, then interest rates of all kinds will follow, including interest rates on commercial real estate.  One offsetting factor are the spreads over treasury rates that lending institutions are charging these days are close to an all time high.  If lenders wanted to absorb some of the rise in treasury rates they could do so by lowering the spreads they are charging.  That is a possibility.  Another possibility is that Congress and the president could pass meaningul legislation to reduce our budget deficits.  I'll let you determine the chances of that happening...

Source: China to 'liquidate' US Treasuries, not dollars; The Telegraph Blogs, by Ambrose Evans-Pritchard, September 15, 2011.

How Bill Gross Got It All Wrong

Earlier this year Bill Gross, the head of bond giant PIMCO, announced in grand fashion that he was getting out of U.S. Treasuries. His reasoning was quite rational: The end of the Fed's quantitative easing program, which ended in June, would be bad for bonds. Prices would fall causing yields (or interest rates) to rise. This would happen because the Fed was the number one buyer of U.S. debt. Without the Fed buying bonds one of two things would have to happen to prevent yields from rising:

1. Some other country would have to step in to buy the Fed's volume of U.S. Treasuries which was highly unlikely, or
2. The U.S. government would have to significantly moderate their borrowing to shrink the volume of U.S. Treasuries being sold on the market. At the present time for every $1 spent by the federal government about 40 cents of that amount is borrowed.

So what do you think are the chances of either #1 or #2 happening? Not likely is it? Looking at it from this perspective, it seemed quite unlikely that another country could purchase the enormous quantity of bonds that the Fed had been buying over the last two years. And it also seemed unlikely that the federal government would reduce its need to borrower.

This past week people were crowing about how Bill Gross got it all wrong and how he lost a lot of money for his bond fund investors. He even admitted sheepishly that it had been a "mistake" to get out of U.S. treasuries. Since Mr. Gross’s announcement in March the 10 year treasury rate has plummeted from 3.46% to 2.02% (Sep 2nd). So how does someone of Mr. Gross's caliber get it wrong? What did he miss?

Back in March when Mr. Gross made his announcement there was no way for anyone to predict:

1. That the sovereign debt crisis in Europe would reach critical mass this year. European leaders had been successful over the years in “kicking the can down the road” and it seemed likely this year would be no different. Wrong!
2. What the impact of the sovereign debt crisis would have on the U.S. treasury market. Fear of a default of sovereign debt by Greece and then by Italy has caused a panic among Europeans. And when panic ensues, investors take their money out of risky investments promising a return on their money and instead invest in less risky investments, in this case U.S. treasuries, where they focus on getting a return of their money.

What has happened is the law of supply and demand has kicked in. Concerned European investors have dramatically increased the demand for U.S. treasuries while the supply has stayed the same. When that happens, yields decline. It’s really that simple.

But the big question is, “How does this affect those of us in the commercial real estate market?” We are currently seeing historically low interest rates.  A lower interest rate means a lower mortgage payment which means better cash flows after debt service. If you own commercial real estate now is the time to lock in long term fixed rate financing.

I know I sound like the boy who cried wolf one too many times but some day we are all going to wake up and the world will be different. Some unpredictable catastrophic event will have occurred (a run on U.S. banks perhaps) causing interest rates to skyrocket and when that happens those who had the foresight to lock in the low rates will be the big winners.

Source: Bill Gross and the Case for Buy Low and Hold, Morgan Housel, The Motley Fool, August 31, 2011.