STREETWISE/Barron’s

 | MONDAY, FEBRUARY 15, 2010

There's Greece - and Also Some U.S. States

By JACQUELINE DOHERTY | MORE ARTICLES BY AUTHOR

Watch the bond-market saga.

BRACE YOURSELF FOR THE SECOND WAVE -- the wave of sovereign defaults that typically occurs a few years after a financial meltdown.

The first sign of what's headed our way may have arrived last week, when pressure on the Greek debt markets was intense enough for the European Union to publicly promise to support the profligate spender. Concern about Dubai's ability to pay its debts re-emerged as well, despite earlier financial support from Abu Dhabi that calmed the market for a short time. Worries about the ability of Spain, Portugal, Ireland and Italy to fund their deficits are also dogging investors.

And before Americans start to feel smug, our own domestic tests are coming from states like California, Illinois and New York, which are facing large deficits. California's 10-year debt yields 4.5%, which translates into a 6.92% after-tax yield. Illinois' 10-year debt sports a 3.77% yield, for an after-tax bonanza of 5.8%. Those are extraordinary levels; municipal debt typically yields less than 10-year Treasuries, currently at 3.69%.

There are credit-default swaps on 50 countries, and all but three have seen widening spreads, notes James Bianco, CEO of Bianco Research. "The whole planet's ability to pay its debt is being questioned," he says.

The risk is that these smaller "subprime" countries and states drag down their larger "prime" counterparts. If the U.S. and Germany need to step in to support their leveraged underlings, they may risk their own debt ratings and funding costs if investors start to question their credit quality.

Exacerbating the situation is the financial tightening in China, which will slow growth in one of the few areas of the world that is growing. "If China is the engine of growth, a Chinese tightening will slow world growth and hurt the countries that need to increase revenue," Bianco says. The thinking is that the world needs bubble-like economic growth to generate the revenues required to service its debt.

Sovereign problems come as no surprise to Kenneth Rogoff, an economics professor at Harvard, who -- along with Carmen Reinhart of the University of Maryland -- was coauthor of a bestselling look back at financial crises, This Time Is Different.

The duo determined that in the wake of financial crises, public debt explodes (thanks in part to bailouts) and revenues decline as tax receipts disappear. Sound familiar? And the bad news is that the process could take five years, some countries will default, and the U.S. could end up supporting some states before all is said and done, predicts Rogoff. As countries and states work through their budget problems, the necessary tax hikes and spending cuts will at best be a drag on the economy and at worst keep the most leveraged entities in recession, he says.

Bond bulls believe that the resulting slow economic growth will help Treasury yields stay low, and Treasuries certainly enjoyed a flight to quality as the world focused on Greece last week. But at some point, if the American states go under the microscope, the quality of U.S. debt could come into question and, Bianco warns, the 10-year Treasury yield could rise to 5%.

Stock investors need to keep track of this bond-market saga for two reasons. Higher interest rates typically mean higher costs for corporations and lower price/earnings ratios on their shares. Neither supports a bull market.