Greece and Dubai: Are the Lights Dimming at the Creditors Ball?

Holders of sovereign debt are not having a very good week. Last weekend, beleaguered conglomerate Dubai World reportedly was thinking of asking creditors to accept a settlement of 60% of the face amount of their debt, or taking a debt for equity exchange. The Dubai stock market dropped away when this story ran, even though Dubai World denied making such a proposal and Dubai debt holders rejected the proposal that Dubai World denied making.

At the same time, the Greek government and EU authorities swapped proposals. The EU wanted the Greeks to put together a detailed program of fiscal reform and the Greeks wanted the EU to announce a detailed bailout package. Aside from issuing dueling press releases, both sides largely eschewed progress.

Neither the Dubai debt kabuki theater nor the EU-Greece Alphonse and Gaston routine disturbed stock markets. From Asia to Europe to North America, stocks rose today, with the Dow Jones Industrial Average increasing almost 170 points on an unexpectedly positive manufacturing report and a drop in the dollar, along with some favorable earnings reports. The stock markets' bounce is bad news for sovereign debt holders.

When a debt crisis clobbers the stock market, governments have to step in. Recall how the mortgage crisis made nervous Nellies of stockholders in 2007 and 2008, forcing the federal government to take over Fannie Mae and Freddie Mac. Then, when the collapse of Lehman Brothers imperiled AIG and Merrill Lynch, the government bailed out AIG, paying its creditors 100 cents on the dollar, and persuaded (that's one way of putting it) Bank of America to purchase Merrill. When Congress initially rejected the TARP legislation in the fall of 2008, the stock market tanked, voters' 401(k) accounts nosedived, and outraged constituents berated Congress back to a second vote that heartily endorsed TARP.

But when the stock market holds up, governments have more latitude to step back and just say no to creditors. That throws the battle for repayment back into the more traditional arena of contention between debtor and creditor, with taxpayers on the sideline.

Since the 2008 government subsidized sale of Bear Stearns to J.P. Morgan Chase, this has been the best of all possible worlds for creditors. Whenever they could conjure up even a faint specter of systemic risk, stock markets panicked and governments paid them out, often at 100 cents on the dollar, no matter how reckless their loans had been. The more stocks dropped, the more leverage lenders had to put the squeeze on taxpayers. But when stocks hold steady or rise, the creditors' cries of wolf sound less compelling. If the stock markets correctly assess that these crises aren't systemic threats, the music will stop playing at creditors ball. As shocking as it may sound, bond holders may have to bear risk and losses.

To be sure, short term price movements in the stock market are often misguided, and the picture may be quite different by the end of this week or the beginning of next week. The European debt crisis doesn't appear to be in a hurry to let up; news stories of a time bomb outside J.P. Morgan Chase's Athens, Greece office indicate that someone's trying to instigate something. The Dubai situation hasn't materially improved since it first blew up last fall, which means that it's deteriorating. Debts fall due as time passes, and the more time that passes in Dubai with no progress, the closer we get to defaults. So taxpayers shouldn't breath easy yet. Lenders may yet find a way to pick their pockets.