Real Estate Forum - September 2011

The debt-ceiling debate led to the S&P downgrade of U.S. debt from AAA to AA+. Although humiliating for the country, the downgrade’s direct short-term economic effects have been minimal, since there is zero risk of the United States defaulting on its debt in the foreseeable future and because global investors have no “riskless” liquid investment option other than investment in U.S. Treasuries. Since the downgrade investors have driven 10-year Treasury rates down to close to 2%. The indirect impact of the downgrade is more difficult to measure, but clearly further erodes consumer and business confidence.

Long-term the potential economic impact of the downgrade is more uncertain, depending on the outcomes of the deficit reduction negotiations, the economic recovery, and the actions of other rating agencies. (Both Moody’s and Fitch have reaffirmed their –‘AAA’- ratings but left the United States on negative watch). Since U.S. debt has never been downgraded, the economy will be operating in uncharted waters and face such issues as:

 Interest-rate increases, should sovereign investors such as China, which holds an estimated $1.5 trillion in U.S. Treasuries, shift their investments to either a new basket of currencies or other types of investments

 Banks, insurance companies, and other financial institutions’ capital reserve requirements treating AAA securities more favorably than lower-rated securities— depending on how regulators view S&P— and future rating actions by Moody’s and Fitch possibly impacting future borrowing costs

 The $4 trillion repo market, which is the lifeblood of short-term financing for banks and other financial institutions, may begin to require more collateral from borrowers using U.S. debt as collateral

 A potential increase in the long-term cost of borrowing, as S&P also downgraded Fannie Mae and Freddie Mac bonds, as well as more than 11,000 municipal bonds tied to the federal government, as part of its downgrade of U.S. debt.

EUROPEAN DEBT CRISIS WORSENS Adding to the uncertainties created by the recent S&P downgrade is the worsening sovereign debt crisis in Europe. Like the U.S. debt-ceiling negotiations, the European Economic Community (EEC), or Common Market, has engaged in a prolonged, tortured process to find long-term solutions to the debt problems of Portugal, Ireland, Greece, and most recently the large economies of Italy and Spain, where the cost of government borrowing spiked to more than 6% in July.

While the recent so-called Greek “settlement” calls for increasing Europe’s main bailout fund from approximately $350 billion to more than $600 billion and requiring Greek bond holders to “share the pain,” the new fund is too small to backstop a crisis in Italian and/or Spanish debt. The agreement, which must still be ratified by member countries this fall, has done little to calm investor fears. Credit default swaps on Greek debt are now pricing with a chance greater than 70% that Greece will default during the next five years.

If the sovereign debt crisis were confined to Greece, Portugal, and Ireland, European banks could absorb the potential losses stemming from a European bailout. Unfortunately, Spain and Italy have been struck by the debt crisis contagion, forcing the European Central Bank to intervene and buy more than $30 billion of Spanish and Italian debt in an effort to stabilize the situation. While this action has driven rates on these bonds below 5%, the effect is only temporary, given the size of Italy’s and Spain’s economics and outstanding debts, which dwarf the combined debt problems of Greece, Portugal, and Ireland.

European banks have close to $1.4 trillion in exposure to Italy—six times the $221 billion exposure to Greece and $1.2 trillion exposure to Spain, according to the Bank for International Settlements. U.S. bank exposure to Italian debt is approximately $370 billion and to Spanish debt $250 billion. In addition, U.S. banks have hundreds of billions of dollars of exposure to European banks, in addition to Italian and Spanish companies.

European banks fund their operations through short-term borrowing in the overnight market. As the situation in Spain and Italy has deteriorated, banks with large Italian and Spanish exposure are struggling to borrow overnight from other banks.