Greece's Problems are the Tip of the Iceberg

Michael E. Lewitt

America celebrates the July 4^th holiday under the threat of homegrown terrorism while global financial markets face a trifecta of threats from Greece, Puerto Rico and China.

And those are just the immediate threats - the world still has to deal with the longer term threat of hundreds of trillions of dollars in debts that it can never hope to pay back and the pursuit of failed central bank policies that are destined to send markets over the cliff sooner rather than later....

The Global Meltdown is Heating Up

Last week, Greece became the first developed nation to default on an IMF loan, Puerto Rico declared that it can never repay its $72 billion of debt, and China's stock market bubble appeared to pop.

At the same time the Middle East continued to spin into chaos, the Obama administration kept begging for a disastrous nuclear agreement with Iran, Russia intensified its invasion of the Ukraine while China intensified its incursions into the South China Sea.

While European stock markets took some gas due to their proximity to the Greek meltdown, U.S. stocks clung to their visions of Goldilocks and pretended that this was all a nightmare from which they would soon awaken.

By the Numbers

The Dow Jones Industrial Average lost 1.2% or 216 points to end the week at 17,730 while the S&P 500 gave up 1.18% or 24.71 points to close at 2076. The Dow is now negative year-to-date while the S&P 500 is up less than 1% (excluding dividends).  The Nasdaq Composite Index, powered forward by bubble stocks like Netflix, Inc. (Nasdaq: NFLX), Amazon.com, Inc. (Nasdaq: AMZN), and Tesla Motors, Inc. (Nasdaq: TSLA), remains the strongest performer of the three indices on the year, up 5.7% year-to-date (excluding dividends). The Nasdaq lost 1.4% last week, however, closing at 5,009. Markets crept into the weekend with their tails between their legs as they waited for the outcome of the Greek referendum on Sunday.

Regardless of whether the Greeks vote "yes" or "no" on Sunday, however, the Aegean drama is likely to play out for the rest of the summer. A "yes" vote would still require a new round of negotiations with the bankrupt country's creditors. And nobody can be sure whether the Syriza government will remain in power or whether a new election will have to be held before those negotiations can take place.

Either way, markets will likely have to endure weeks of uncertainty before there is even a modicum of stability in the region while the Greek people are prone to suffer severe hardships in the interim. The Financial Times is reporting that the Greek government is considering imposing haircuts of up to 30% on Greek bank deposits above €8,000, which would be disastrous for already an already strapped populace.

Back here in America's own Greece - Puerto Rico - creditors are starting to face up to what are likely to be tens of billions of dollars of losses on the territory's $72 billion of debt.

A mere 15 months ago in March 2014, Puerto Rico sold $3.5 billion of 8% Series A General Obligation Bonds due 7/1/35 at a discounted price of 93 in order to repay some short-term debt. At the time, I warned that buying these bonds was like throwing money in the garbage, and my warning has proved all too accurate. Today the bonds are trading in the high 60s after Puerto Rico's Governor Alejandro Garcia Padillo warned that the island cannot pay its debts. Investors in these certificates of loss have now collected 10 points of interest and lost 27 points of principal in a mere 15 months and are about to see their interest payments stop and their principal erode further.

Some smug municipal bond managers - who are, let's face it, the lightweights of the investment world - are boasting that they own only insured Puerto Rican bonds. Well, I have a bulletin for them - good luck trying to collect on that insurance. Last week, the stocks of bond insurers MBIA, Inc. (NYSE: MBI) and Ambac Financial Group (Nasdaq: AMBC) fell 30.9% and 25.1%, respectively, based on concerns about their exposure to the bankrupt island.

According to BTIG analyst Mark Palmer, MBIA is facing potential losses of $4.9 billion on Puerto Rico while Ambac could see a $4.5 billion hit. Have you ever tried to collect an insurance claim? These companies will fight tooth-and-nail not to pay and may not be able to pay even if they must.  Investors whose muni managers own Puerto Rican bonds in their portfolios need to start shopping for new managers. Anyone with a functioning cerebellum could see Puerto Rico's default coming from a mile away.

A China Crisis is Well Underway

The final leg of the disastrous trifecta hitting markets last week was the collapse of China's stock market bubble into bear market territory. The Shanghai Composite Index has now lost 28% in less than three weeks while the Nasdaq-equivalent Shenzhen Index has collapsed by 33% during the same period. The ChiNext index of small companies has also lost 33% during this period after tripling over the last year.  The Chinese government was attempting to shift speculation from its overheated real estate market to the stock market and now has an epic mess to clean up.

The Chinese authorities have resorted to an increasingly desperate series of moves to prop up these markets, the latest being Chinese brokerage firms coming together to set up a stock market fund to prop up the market. A group of 21 brokers led by Citic Securities Co. will invest (and likely lose) the equivalent of 15% of their net assets as of the end of June (the equivalent of $19.3 billion) in the blue-chip exchange traded funds.

There is little chance that this plan, like the previous attempts to prop up the bubble, will work. The real question is whether the popping of China's stock market bubble will affect the overvalued U.S. market, which seems to be hanging on to the thread of hope that things will stay bad enough to keep the Fed from raising rates in September. The latest jobs report showed that an "official" unemployment rate of just 5.3% but the lowest labor participation rate since the 1970s.

Over 400,000 people again left the job market for various reasons. If the labor participation rate today were the same as when Barack Obama took office in January 2009, the "official" unemployment rate would be north of 11%. The reasons for this, however, are structural rather than cyclical, meaning that low interest rates aren't going to fix them. The longer the Fed keeps rates at zero, the worse things are going to get.

At some point, maybe stock investors will figure this out and start to hedge their gains or limit their equity exposures before they end up in the same place as the Chinese farmers who thought they could get rich quick and are now finding out there are no free lunches in any of the world's restaurants.

Michael E. Lewitt

About the Author

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Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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