Where Will the Debt Go?

Standard & Poor’s downgraded Italy’s credit rating by one notch yesterday. Italy has debt at 120% of its GDP, or around $2.5 trillion. Unfortunately, Italy has to roll over approximately $67 billion worth of bonds by the end of this year. With yields on Italian debt rising, this becomes more expensive.

The ECB has bought Italian bonds already. It may buy more. But that doesn’t change the fact that investors will become more nervous about Italy as Greece comes closer to default.

I’ve said I think Greece will indeed default on its debt, which totals around $500 billion.

The New York Times today says that the market is pricing in 60% default. That is, bond holders would get $0.40 one the dollar for their Greek bonds. It’s also reported that Euro-banks have written off Greek debt to the tune of around 20%. That means they still have a ways to go.

Merrill Lynch says that the worst-case scenario for French and German banks is a $543 billion hit. That would include the 20% they’ve already written down. Now, I haven’t seen the numbers so I don’t know how these banks would lose more in value than Greek outstanding debt. The point is really that Euro-banks have more work to do in writing off their Greek exposure.

For Greece to pay off its debt, at a time when its economy is shrinking 5% a year or more seems unrealistic. So why not just step up and state the obvious?

In fact, default – or debt forgiveness – is an option for mortgage debt in the U.S., too. I know the "pull yourself up by your bootstraps" crowd will disagree, but something has to be done about the housing market. Too many people are underwater, and despite low interest rates, many can’t refi their loans.

To me, a massive round of refis would help immensely. Get those underwater loans off the books, free up the associated loan loss reserves, and put a whole new mortgage debt structure in place.

The main impediment here seems to be credit scores. Anyone that’s struggling, or had a loan modification, probably has a credit score that precludes refis, regardless of income and job stability.

I would suggest one reason the Fed has kept rates low is to allow for refis. But the banks won’t/can’t engage in refis due to credit scores and the perceived risk.

For the record, I am a "pull yourself up by your bootstraps" guy. Nowhere is there more opportunity to better one’s self than in America. But at the same time, we as a country should also recognize the massive failure that the housing bubble represented. It was complete, from banks, to borrowers, to regulators, to policymakers, to analysts, to investors and economists.

This may not be the best time to bring it up, but 3Q earnings season is right around the corner. Alcoa (NYSE:AA) reports on October 11. No sector has received larger earnings revisions that the banks (and yes, those are lower revisions).

Last quarter, bank profits were massively inflated by returning loan loss reserves to earnings. Here’s a quick rundown:

JPMorgan Chase (NYSE:JPM) reported net income of $5.4 billion during the second quarter, boosted by a $1.2 billion reserve release. For Citigroup (NYSE:C), second-quarter earnings of $3.3 billion were helped by a $2.2 billion decline in loan loss reserves. Wells Fargo (NYSE:WFC) reported second-quarter net income of $3.9 billion, with its bottom line directly boosted by a $1.1 billion decline in reserves. For Bank of America (NYSE:BAC), the pain of a $8.8 billion second-quarter loss was somewhat eased by a $2.5 billion decline in loan loss reserves.

It will be very interesting to see how banks come in, and how much in loan loss reserves they can return.

At some point, banks will get healthy again. And they are essentially the last sector that’s still feeling the effects of the financial crisis (because they’re the ones holding the debt).