Living In Financial Fantasyland

by: Thomas J. Feeney

We're living in an era of make believe. With the acceptance of newly issued Greek bonds, holders of that nation's debt are making believe that Greece is still a solvent country and will someday pay its debts. To get to that point, bondholders around the world had to make believe that they "voluntarily" forgave an estimated 79% of the money Greece owed to them.

Now we have to make believe that many of the European banks that hold the debt of Greece and such other strong sovereign credits as Portugal, Italy and Spain really hold assets worth what they're valued to be on the banks' books. Perhaps concerned that such a financial fiction was too much of a stretch, the European Central Bank twice in the last few months loaned Eurozone banks as much money as they wanted for three years at a mere 1% interest. Where did that money come from? In an era of make believe, there's no good reason not to create it out of thin air.

In the United States, we have more debts and promises of future payments than we will ever be able to pay. We are adding to that debt load by more than $1 trillion a year. So far, stock and bond investors are making believe that an unpayable debt load doesn't really matter. Somehow, it will all work out in the end.

Right now, equity investors--at least in this country--are focusing on improving business conditions resulting from the most monumental rescue and stimulus effort in history. If they view these debts as a problem, it's clearly not today's problem. Analogously, this seems to be a case of concentrating on a relatively healthy grove of blossoming trees while overlooking a pernicious blaze growing in an adjacent section of the same forest. The safety of the blossoming trees is heavily dependent on remaining isolated from the blaze. Winds, however, are variable and unpredictable, like investor attitudes. Should events like rapidly rising interest rates in Portugal, Italy or Spain or a political impasse over the U.S. budget deficit lead investors to focus on the long term debt realities, winds could shift direction and intensify. The debt blaze has the potential to overwhelm even the healthiest grove of trees.

As we have stated repeatedly, markets can continue to perform well so long as governments and central banks can keep looming debt disasters out of investors' consciousness. And they are obviously bending every effort to do exactly that. So far, they have kept the blaze from consuming the forest.

Firefighters frequently set small backfires to prevent potentially lethal forest fires from spreading. World central bankers (as firefighters) have set any number of such backfires in the form of increased liquidity. Unfortunately, by using massive blast furnaces instead of modest blowtorches, our firefighters have increased the risk that when the wind shifts, the ultimate conflagration will be far worse than the original blaze.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.