Is Sovereign Debt the New Subprime?

Is Sovereign Debt the New Subprime?

That’s a question many on Wall Street are asking as 2009 comes to a close. Just as many subprime borrowers were unable to make their mortgage payments in 2007 and 2008, investors now fear certain nations will be unable to pay their debts in the year ahead.

Rising mortgage defaults and credit card delinquencies put many banks on the brink of bankruptcy in 2008, sending the global economy into a tailspin. But sovereign debt defaults are potentially even more catastrophic as they can lead to geopolitical instability, societal unrest and even war. And there will also be economic ramifications for investors worldwide, putting America’s (and the globe’s) fragile recovery at great risk.

To varying degrees, Greece, Spain, Ukraine, Austria, Latvia, Mexico are just a handful of the nations viewed at risk of defaulting. Meanwhile, Dubai only just avoided a similar fate thanks to a $10 billion bailout from their oil-rich neighbor Abu Dhabi.

So, who else out there could rattle our constantly more interconnected world? Here's a look at where the trouble spots could be:

• Greece: Fitch Ratings last week joined two other ratings agencies in expressing concern about the country’s health. “Greece faces the risk of sinking under its debt,” Prime Minister George Papandreou said Monday in a speech where he pledged to slash the nation’s budget deficit by overhauling the nation’s tax system and cutting government spending.

• Ecuador, which defaulted in December 2008 when President Rafael Correa said the nation wouldn't make an interest payment of more than $30 million on a $510 million bond issue, carries a CCC+ rating at S&P. They define the debt issuers in the CCC category as "[c]urrently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments." Translation: Probably in for hard times.  

• Argentina, Grenada, Lebanon, Pakistan and Bolivia are judged to be a little better off, but they're saddled with still dubious B- ratings. The single-B classification at S&P means these nations are "[m]ore vulnerable to adverse business, financial and economic conditions but currently [have] the capacity to meet financial commitments." Translation: Not good, and needs some things to go right, preferably soon.

• Mexico: This week, S&P cut some of its ratings on America’s southern neighbor, but said the outlook is stable. Why the move? Because the agency believes Mexico's attempts to raise money through sources other than oil revenue and to make the economy more efficient "will likely be insufficient to compensate for the weakening of its fiscal profile." Put it on your watch list.

• Spain: Before you go thinking that problems can only emerge from closed regimes or places economists have stuck with the "developing" tag, think again. Earlier this month, Spain's outlook was dropped to negative from stable by S&P, owing to fears the nation "will experience a more pronounced and persistent deterioration in its public finances and a more prolonged period of economic weakness versus its peers."

What Is Sovereign Debt?

Now that we’ve (hopefully) got your attention, here are some definitions for those unfamiliar with the subject:

“Sovereign debt” refers to the debt of nations. Just as the U.S. issues Treasuries backed by the “full faith and credit” of the government, other nations sell bonds in order to raise money to pay for programs ranging from armies to public healthcare.

A “default” refers to a nation’s inability (or refusal) to repay its debt. Whether a homeowner sends “jingle mail” (home keys via post) because a lost job makes mortgage payments impossible or because a drop in home values makes paying the mortgage uneconomical, the effect on the bank is the same: they lent money and now they’re not getting it back.

The same goes for investors who’ve purchased sovereign debts. This is critical because nations’ debt is often viewed as safer than corporate debt since countries have the ability to raise taxes and increase tariffs in order to raise money to pay their debts.

But “safer” is not the same as “safe” and certainly not guaranteed. There are risks in owning nations’ or sovereign debt, as with any stock. Defaults by Argentina in 2002 and Russia in 1998 are just recent examples in the long history of sovereign debt defaults going back to the Spanish empire in the 1600s.

In a new book “This Time Is Different”, economic professors Ken Rogoff of Harvard and Carmen Reinhart of Maryland, detail the history of sovereign debt defaults, noting common traits, including:

High Debt-to-GNP Ratio

Since 1970, nearly half of sovereign defaults have occurred in nations debt-to-GNP (gross national product) ratios of 60% or more. This makes sense: As a country’s debts start to approach the size of its total economy (or GNP), it gets harder to make the payments, just like a individual whose debts start to eat up all (or most) of their salary.

Countries like the U.S. and U.K. have triple-A ratings, meaning they are considered the strongest in terms of the ability to repay their debt. (The ratings from top to bottom are based on the alphabet, AAA being the best to CCC meaning the financial world doubts your ability to pay the money back.) However, some experts worry about those pristine ratings being in jeopardy as Anglo-Saxon nations continue to accumulate massive amounts of debt to pay for spending, and to take on the recession.

A World of Risk

Few investors seriously worry about an imminent default by the U.S. or the U.K. But with worries about Dubai's ability to pay its debts shaking markets across the globe in recent weeks, investors are on guard about which other countries might be in dire financial straights.

Ratings agency Moody's, for example, said Tuesday that the upcoming year could be a rough one for government debt, issuing a report depressingly titled "Fasten Your Seat Belts: Tumultuous Times Ahead."

Anyone with access to the business pages knows individuals, banks, companies and governments everywhere have a serious problem -- just how bad it is and how long it will last is still being sorted out. Unfortunately, we probably still have a way to go before brighter days return.