The Greek Ruins

Let’s begin today’s edition with a riddle:

What location in the world is famous for its sun-drenched beaches, azure seas, arid Mediterranean climate, rugged coastlines, olive trees, earthquakes, smoggy cities, hedonistic mythology, dismal government finances and well-preserved antiquities?

That’s right, California.

If you answered “Greece”, you did not read the riddle carefully. The antiquities of Newport Beach are far better preserved than anything you could find in Athens. Furthermore, Greece’s government finances are not merely “dismal,” they are horrific.

California is facing a budget deficit this year of about $40 billion, which is roughly equivalent to 2% of the state’s $2 trillion economy (GSP). That’s dismal. But over on the Mediterranean, Greece’s budget deficit is on track to hit $50 billion, which is a very big number for an economy that is one fifth the size of California’s. In fact, that’s a horrific number. What’s more, Greece’s accumulated debt totals $443 billion – a whopping 113% of GDP.

Neither California nor Greece can print their own currencies, of course. So both of these borrowers must rely on traditional remedies, like cost-cutting and bailouts…or just bailouts. This is where the chart below comes into play. It tracks the pricing of credit default swaps (CDS) on 5-year bonds from California and Greece. [Simply stated, a CDS is an insurance policy against default. The higher the CDS price, the higher the cost of the insurance. At the moment, the price of a 5-year Greek CDS is about 375 basis points, meaning it would cost about $375,000 to ensure $10 million worth of Greek government bonds for five years].


For most of the last 15 months, CDS investors have been assigning a higher probability to a California default than to a Greek default. About a month ago, however, investors changed their minds…but not by much. At yesterday’s quotes of 375 bps for the Greek CDS and 325 bps for the California one, the pricing differential between the two is little more than a rounding error. So what do these CDS prices imply? Are the finances of California and Greece merely the twin sons of different mothers?

Probably not.

The sky-high prices of California CDS may have more do with the state’s sky-high profile than its large deficits. According to yesterday’s CDS prices, for example, California (and Greece) were both riskier credits than El Salvador, Bulgaria, Lebanon or Kazakhstan. Heck, they were riskier than New Jersey. Greece might belong in this company. California probably does not.

Net-net, the surprising similarity between California and Greek CDS prices probably says more about their respective prospects of a bailout than about their underlying finances. California’s finances are poor, but so far the federal government has refrained from offering assistance. Greece’s finances are abysmal, but the nations at the core of the European Union are rushing to help.

So what’s all the fuss about? Why would France, for example, worry about saving Greece? The answer may be that France doesn’t care about Greece at all. But France does care about France.

As it turns out, French banks are sitting on $75 billion worth of loans to Greece. Even more troubling, French banks are sitting on another $775 billion worth of loans to the other “Club O’ Med” countries (Portugal, Spain, Ireland, and Italy) that reside on the fringes of EU viability.

Therefore, as London’s Daily Telegraph observes, “Germany [and France] face a Hobson’s Choice: if loan guarantees for Greece turn into a slippery slope towards implicit support for the whole of the ‘Club O’ Med’ (Portugal, Spain, Ireland, and Italy), EU creditors could be tainted by contingent liabilities worth trillions. Yet failure to reach a deal risks a sovereign version of the Lehman crisis.”

No wonder then that Germany and France are diving into the water to rescue the drowning Greeks. But did you ever see how a drowning man treats a lifeguard? The lifeguard dives into the water and speeds toward the drowning man. Once the lifeguard arrives, however, the drowning man, in an effort to keep his own head above water, grabs hold of the lifeguard and plunges him under the water.

The lifeguards in Europe may be slipping under the waves already. During the brief period of time that the French and Germans have contemplated a Greek rescue package, the perceived risk of a French government default has more than doubled, according to CDS pricing. At the same time, 10-year French and German bond yields have both jumped about 15 basis points.

Your California editor has no idea how the Greek crisis will unfold. Nor does he have any idea how his beloved state will make it from paycheck to paycheck, or what lifeline Governor Schwarzenegger will attempt to latch to the state’s budget. But your editor suspects that every lifeline in the water – whether it is latched to California or Greece or AIG or Portugal or Goldman Sachs – is secured on the other end by a tragically flawed economic theory and/or a printing press.

So if you are a nimble investor, go ahead and try to trade off the bailout headlines. But if you aren’t, buy a little gold. And whatever you do, avoid long-term government bonds – our Daily Reckoning short-sale of the decade!

By Eric Fry

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