Why you should care
This is what’s at stake for investors given all the chatter about defaults on debt in Greece and Puerto Rico.
The writer is a New York-based journalist and the author of The WSJ Guide to the 50 Economic Indicators That Really Matter.
Up, down and all around — global stock markets have been giving investors quite the ride this week. But is the financial world on the brink of another crash? Most people could be forgiven for thinking so given news about Greece missing a roughly $1.7 billion loan payment to the International Monetary Fund and Puerto Rico’s governor warning that the territory simply can’t repay $72 billion of debt. The feeling of impending collapse was only exacerbated when stocks in Europe and the U.S. tumbled on Monday, before bouncing back later in the week.
But what’s really going on is something other than economic Armageddon. It’s more like ripples traveling across the surface of a pond — picture a stone hitting the water’s surface, causing a splash and then mini waves radiating away from the impact point. Eventually calm returns. It’s been a similar scene this week in the financial markets, in which fluctuating stocks are reflecting the changing flows of capital.
The euro could be called into question.
Joe Brusuelas, chief economist at accounting firm McGladrey
There are two separate reasons why markets reacted the way they did to Puerto Rico and Greece. But there’s one underlying cause of why things got so bad for them in the first place: “too much easy money,” says Woody Dorsey, a behavioral finance expert and the author of the Sentiment Timing and Market Semiotics newsletters. Or, to put it another way, the low cost of borrowing brought on by central banks around the world allowed both Greece and Puerto Rico to borrow so much that they now basically can’t pay back their respective debts.
Even so, the specific ways that Greece and Puerto Rico affected the markets are very different. For Greece, the big issue for all investors is that the default has raised a level of uncertainty about the future of the euro. “The euro could be called into question,” warns Joe Brusuelas, chief economist at accounting firm McGladrey. In general, of course, investors hate uncertainty. The more of it there is, the less they like investing — or the more they will charge to lend money.
What happens in Greece is also being compared with what might happen in some of Europe’s other indebted countries such as Spain, Portugal and Ireland, explains Brusuelas. In particular, if Greece doesn’t pay back what it owes, some lenders could come down heavily on those other countries, he says. And if the euro does collapse, it will change the way business is done in Europe in a big way. Just imagine having to change money if you traveled from New York to Pennsylvania and wanted to buy something — that might impede trade somewhat between those two states. That could be a real worry for Europe.
The result overall is that investors quickly marked down the prices of shares in Europe and the U.S. — but Puerto Rico is a different matter. “I actually am more worried about Puerto Rico than Greece,” Jeffrey Saut, chief investment strategist at brokerage Raymond James, wrote in a recent research note. How so? He points out that not many hedge funds owned Greek government debt, but many do own Puerto Rican bonds. When hedge funds buy and sell securities, they frequently do so by borrowing with margin debt. It’s like layaway for brokerage firms. The fund puts down a small deposit (or margin) on the security and then pays back the loan when the security is eventually sold.
The problem comes when the value of the security falls too much. And that’s exactly what happened earlier this week when Puerto Rico’s governor said the island was broke. Last week, Puerto Rico’s debt, due in 2035, was being bought and sold for around 77 cents on the dollar, according to Janney Capital Markets. On Monday, the price dropped to less than 70 cents. On that news, the immediate reaction of brokers would have been to ask for more cash from the hedge funds that had purchased the securities using margin.
So what does the hedge fund do instead? Sell other securities to raise the cash needed to cover the new margin requirement. And because the Puerto Rican debt was so widely held by hedge funds, there would have been a lot of selling, causing large ripples through the financial markets.
The good news, for now, is that the Puerto Rican situation is “fairly contained,” says Adam Mackey, head of municipal fixed income at PNC Capital Advisors. But, he adds, it could have an impact on the broader municipal market — that is, the market that states and local authorities use to borrow money. Broadly speaking, that could mean higher borrowing costs for local governments that don’t have the best credit.
For both Greece and Puerto Rico, the road back to whatever normal is will be neither fast nor easy, though it’s still a long way from Armageddon.