This is the first in a planned series exploring why the global economic recovery continues to defy expert projections and remains on the path to collapse.
Last year I told friend I didn’t expect the U.S. economy would make it until Christmas without hitting the default wall and, on one of those windy, snow-filled February days, I began searching for clues why our governmental policies hadn’t already wrecked the economy. The alarm bells were ringing but specifics were hard to find. As time passed, I thought I had misread the situation and ignored the bells.
An editorial in the June 27th Wall Street Journal titled “Money Market Mayhem” reawoke the bells with an insistence that couldn’t be ignored. In the article the WSJ claimed the U.S. money market industry was accumulating “European bank debt, even while knowing those banks had stocked up on bad sovereign paper. The U.S. Treasury is even saying privately that the U.S. needs to support the European bailout of Greece lest Europeans banks fail.”
Two days later the bells were back at work again on a piece from the Daily Reckoning asserting “money market fund managers have lost their way…taking on riskier and riskier investments for smaller and smaller returns.” The DR then added, “Three years after nearly dooming the U.S. financial system by buying American government-backed garbage, the money funds are at it again, buying Europe’s PIIGS-backed garbage.” PIIGS is an ancronym for the financially-troubled Portugal, Ireland, Italy, Greece and Spain.
All you need to understand is the basic accounting equation–assets equal liabilities plus equity–in order to hear the alarm bells. Assets are items which have value and can be converted into cash in order to cover liabilities, liabilities are what is owed to others and equity is the worth of the firm when the dust is settled. Until recently, any government-backed asset was considered to be of the highest grade.
The money market industry immediately defended itself against these two opinion pieces. Paul Schott, CEO/President of Investment Company Institute, acknowledged the funds are buying this junk debt but qualified his defense with “in the case of banks with prime money market funds portfolios, in every case the bank’s direct exposure to Greek debt is less than 1% of the bank’s total assets.” If you stick to Schott’s assessment, he is accurate. But this caused the alarm bells to up their clamor because it is so limited in view and there are two other parts of the equation besides assets.
I began comparing the industry’s government paper debt for all five PIIGS against their equity. The questionable ratio of bad debt to equity wasn’t less than 1% now but more than 44% of all assets and in most cases completely eliminated the company’s equity. The ringing bells could have drowned out a Navy klaxon sounding less than a foot from my ear by now.
Further comparisons showed the Money Market funds weren’t the only ones in PIIGS debt this deep either. Bigger names like BNP Paribas, Societe Generale and Deutsche Bank overseas plus firms like Bank of America, JPMorgan Chase and others in America also tilted heavily towards government debt to the point all liabilities were no longer covered. I used data provided by Grant’s Interest Rate Observer up to this point and then I added one more “junk” item to the equation, U.S. debt to get a true grasp of the problem.
It is considered heresy to put the AAA-rated U.S. paper into the same category as the PIIGS but what is the difference. America’s ability to repay its debt is in serious doubt. America’s mental willingness to repay has long since joined the dodo and passenger pigeon. We’ve come to accept mind-numbing debt as a norm. Indeed America may be closer to the economic wall than Europe and our unprecedented debt level will dwarf anything Europe can manufacture when that tsunami hits shore.
Greece, sooner or later, will default. The Greeks have done it before and neither the Greeks nor anyone on the outside seems willing to let the Greeks break that cycle. Ireland and Portugal are on the cusp of default (when even Moody’s and S&P’s can see the problem you know it is bad!)
Spain and Italy are merely waiting for one of the others to drop before they renege on their unmanageable debt.
The vicious cycle is centered in the European Central Bank (ECB). The ECB lent Greece 90 billion euros at a time when the Greek government could only muster 815 million in assets. Any money man, anywhere and at any time unless they have a personal stake in that kind of loan will tell you more than 99:1 unprotected loan is not done. But the ECB wasn’t through. In quick order it sent 106 billion to Ireland, 48 billion to Portugal and 44 billion to Spain. Italy has also put out a call for help but the ECB hasn’t released any numbers on Italian aid as of yet. On just the known PIIGS loans, the ECB is insolvent. The rest of the Euro Union’s central banks are also deeply dependent on the continued survival of the PIIGS. Not because they have any love for those miserable states but their own survival is at stake. You see, they too hold a lot of PIIGS debt.
So the allegedly quiet centers of London, Berlin, Paris, Amsterdam and Brussels have no choice but to bailout the PIIGS or they too drown in red ink. And the rest of the world’s leading central banks, including the U.S. Federal Reserve, are in the position of having to support their worthless investments in these countries through on-going loans. For once the loans cease, default is the only option. As long as the PIIGS are given crutches to stand, the central banks stand. If the PIIGS fall, the rest of the central banks are essentially bankrupt as well.
Real numbers in individual American companies’ funds look ugly too. Vanguard Reserve Prime (VMRXX) is a beautiful example. It has 24% of its government assets in Europe but a hefty 52% in American debt. In essence, an impartial observer could conclude VMR’s assets should be downgraded by 76%. How’s that equation working out for its investors now? If those countries don’t default but are supplied a lifeline again, VMR will have time to divest itself of that paper but who will buy?
The problem with the lifeline of loans, is that money no longer exists in the private sector so governments around the globe are going to have to invest their citizens’ future even deeper into these pits.
Make no mistake, this affects every individual in the lending countries. In addition to the money market funds, entities like local banks, insurance companies and pension plans are heavily invested in government-backed debt. Everyone has these assets in some form or another. Take car insurance for instance. If there is a default, premiums will shoot upwards until they will no longer be in reach of most people. A local company, whose service is required, loses its cash reserves in a money market fund, where then will the service or product come from? This is not a rich-only liability. The effects will flood the rest of the economy, particularly on Main Street (government has ignored you before in its’ “Too-Big-To-Fail” policy).
This means, again, old standards determining stability and providing long-term planning for the individual will have to be re-examined. In most cases it will be found the anticipated resources needed for the long haul are no longer available. Economically, this reliance on government bondage puts everything on very unstable ground and what was thought of as valuable will turn out to be mere thin air.
And my alarm bells continued to thunder.
Next Up: A look at how specific companies with long ties to our government were involved in covering up and profiteering from the PIIGS’ problem–to your eventual expense