The Markets and Sovereign Debt

It’s interesting to see the stock market fluctuate so much based on the news. When the US government struggles to handle its debt problems, the US market indexes go down. When another story about struggling Greece, Italy, Spain, and Portugal hits the news, the indexes drop some more. They swing back up when there’s news of a deal. Usually the deal is in the form of a loan from an oversight body, or reduced interest rates so these in-debt countries can borrow money more cheaply. The deals being made so far have not actually solved many or any of the fundamental problems – that governments are spending too much money.

MF Global and Sovereign Debt

MF Global was a company run by John Corzine, former New Jersey governor. As its head he began buying up tons of risky European debt from countries such as Greece, Italy, Spain, and Portugal. It’s considered risky because these are the countries closest to default on their loans. Default would mean Corzine’s investments wouldn’t pay out and his firm would stand to lose a lot of money. The ratings agencies saw what he was doing, considered it risky, and downgraded his company to junk status. Once his company was rated as junk, it was much more difficult to get the loans needed to operate on a day-to-day basis. He needed loans to operate because his company had $1.4 billion in equity leveraged against $44.4 billion in liabilities. The stock tanked and they couldn’t raise money through selling off a part of the company. Bankruptcy was declared. This opinion piece in the New York Times provides some good info.

Has Italy defaulted? Has Greece defaulted? No and no. So his big bet could’ve worked out. He just needed to take it a little slower. And of course, the European community would’ve had to come through for him.

Analysis of Countries’ Debt

For all our sakes I hope every country can get their financial house in order, if only because confidence in governments’ financial well-being impacts confidence in the equities market in general. Why are stock markets that reflect mostly private business so intertwined with government financial responses? I suspect in part because countries have central banks that play a role with loans to other banks, which in turn can impact liquidity (available cash to transact business). Maybe another reason is related to taxes - if a government has money problems it might have to increase taxes on businesses to make up the difference, which would lead to less profit. There are likely more reasons but I haven’t researched this issue. Regardless, there is a link between the two systems (private business and government).

One confirmation of the link is a common metric used to analyze a country’s economic health: the “Debt to GDP” ratio. Debt usually means government debt (excluding private debt). GDP can be calculated differently, as shown in Wikipedia and Investopedia, but basically it’s the size of the economy (including the impact of government - thus GDP is a blending of private and public money). The Debt to GDP ratio is usually expressed as a percent - 60% would mean if debt is 6 trillion, GDP is 10 trillion (in a given year).

What’s a good Debt to GDP ratio? There appears to be no consensus (maybe we need a new metric - one that does a better job of indicating ability to pay back the debt!). Here’s an article that talks about the ratio and generally encourages countries to get into financial shape. Japan has a ratio over 200%! Italy, Greece, Portugal, and Ireland also have bad ratios. Here’s the Wikipedia site showing all countries’ 2010 ratios. The US is around 62%. Here’s a website with tons of cool debt-related graphs.

What to Do While Countries Are Figuring Things Out

Play the market’s ups and downs, baby! Sell an index fund after the markets have reacted to good news; buy one after the reaction to bad news is over.

Just kidding... sort of. If you have play money to work with, why not give it a try?