Will financial trouble in Greece echo in the US?
June 30, 2011
The events now taking place in Greece should not be underestimated. There is political and financial chaos, and some of that discord is plainly filtering into the international financial system.
Is this a concern for the U.S.? Could our mortgage quotes be impacted?
If the only problem were Greece there would not be much of an issue. The country's small economy could easily be assisted with international efforts while at home there would be higher taxes and fewer jobs.
But in addition to Greece there are also different--but troubled--economies in Iceland, Portugal and Ireland. If you listen to the rumor mill, there are actually a few other countries which might be ready for the international watch list.
National economic trouble is never a good thing because the results are pretty much known in advance: To fix the economy it will be necessary to cut jobs, raise taxes and increase interest rates, including mortgage rates.
Long ago you could invest in a currency that was appreciating at the rate of 20 percent per year. What was not said was that the money was being devalued at the rate of 21 percent per year. In other words, inflation made the deal a sure loser despite the apparently high interest rate.
Insurance for Greece
Interest rates in Greece will rise, in part because of the greater risk represented by a fragile economy but also by another factor which is not often mentioned: Insurance.
Investors who take money to iffy locations want more than interest. They also want insurance. In effect, the high interest rate is a response to income risk and the insurance from a strong third party is hedge against the loss of principal.
It works like this: Investors want protection against default. The greater the perceived risk, the higher the premium. The premium cost is ultimately reflected in the interest rate.
The Wall Street Journal reports that to insure a $10 million investment in Greece now costs $1.7 million a year--17 percent. That's not a cost for interest, that's a cost in addition to interest.
So, what about the U.S.?
If the federal government defaults on a single dollar of debt--something that could happen if the debt ceiling is not raised by August 2nd--then all bets are off. The cost of external capital will soar, meaning far higher interest rates for cars, houses, and businesses. Those with adjustable-rate mortgages will be hard hit while those with fixed-rate financing will have a hedge against rate inflation.
Also, even if a deficit deal is worked out, many ARMs in the United States have interest rates which rise and fall with the LIBOR--the London Interbank Offered Rate. Interest levels for the six-month and 1-year LIBOR have actually been falling so far this year, but what about next year? Or the next few months? Little wonder that most opt for mortgage rates that are fixed.
