Greece: Bond Vigilante Target
A European Union and Greek flag wave in front of the Parthenon in Athens. Can events in Greece affect your life? REUTERS/John Kolesidis

As European officials work diligently but, at times, very grudgingly toward a restructuring of Greece's debt, U.S. readers and investors may be wondering, What impact does all this Greece stuff have on me?

Some argue that Greece doesn't matter or that Greece is irrelevant, it's a European issue.

Greece Matters

Each is wrong: Greece matters. And Greece is most relevant for Americans. Here's why:

Q: What are the latest developments regarding the Greek debt crisis? Will Greece default?

Three key developments Wednesday:

First, the European Central Bank (ECB) agreed to continue to buy debt-plagued Europe nations' bonds to combat market turmoil, including bonds from Greece and other high-debt Eurozone nations, Reuters reported Wednesday. The ECB also said it will lend 91 banks €56.9 billion or $79 billion for 12 months, and also make €44.6 billion in three-month loans, when they mature, Bloomberg News reported.

Second, equally significant, German Chancellor Angela Merkel Wednesday afternoon won approval from Germany's lower house, the Bundestag, 503-89, for an increase in the Eurozone's rescue fund -- the European Financial Stability Facility (EFSF) -- to help end the financial crisis in Europe, Bloomberg News reported Wednesday.

Invoking Germany's historic obligation to defend the euro and Europe, Merkel said, in so many words, the eyes of the world are on Germany, and the benefits of the rescue outweigh the costs to Germany.

The world is watching Europe and Germany, Merkel said in a speech Wednesday to the Bundestag, Bloomberg News reported Wednesday. It's watching whether we're ready and able in the hour of Europe's deepest crisis since the end of World War II to accept responsibility.

Third, on the heels of Germany's critical and historic vote, European leaders will now meet to discuss a new, wide-ranging and complicated framework to end the crisis. Bolstered by Germany's approval of a larger bailout fund, European leaders will almost certainly now increase the size of the bailout fund; they may also recapitalize selected banks that need it, agree to write-down or cancel a portion of Greece's debt or choose to guarantee that debt.

The first two acts by the ECB and by Germany are rays-of-light toward resolving the Greek debt crisis, and the European leader meeting, if it results in less Greek debt or less risk associated with owning Greek bonds, would be the third.

Further, the markets, if the initial response is any barometer, indicated as much Wednesday afternoon: Europe's stock markets were unchanged, and the euro weakened only seven-tenths of one U.S. cent to $1.3819.

To be sure, Greece is still in danger of a default, and has much heavy-lifting, from a fiscal standpoint, ahead. Greece must follow-through on another round of spending cuts and probable tax/fee increases, and Greece's citizens, as evidenced by recent social turmoil, may not be receptive to still more cuts. In other words, the risk remains that Greece will still default, but that risk meter is slightly lower now, due to Germany's bailout approval and the ECB action.

Q: Will interest rates rise if Greece defaults on its debt or has to restructure its debt?

A: Briefly, yes, if Greece defaults. If it has to restructure, it's possible that interest rates will rise, but they may not. Although Greece is a small country with an equally-modest economy, 2010 GDP of $305 billion, Greece is not an insignificant credit market participant. Germany and France have a loan exposure of more than $400 billion to Greece, hence if their banks are hurt by losses on Greek bonds/loans, that would almost certainly lead to an increase in interest rates in Europe, and the United States, including home mortgage rates. The average 30-year,-fixed-rate mortgage, currently 4.20%, as tabulated by, would rise substantially in weeks, if not days.

There's also the distinct possibility that credit markets would tighten again -- and that would affect the amount of money available for mortgages. The capital source for many mortgages is the bond market, hence the term mortgage-backed securities, and fewer bonds would mean a smaller the supply of funds available for mortgages.

The net result? At least some banks, if not many, would decrease the number of mortgages they approve -- they would choose to lend to stronger-credit borrowers over weaker-credit borrowers -- and that could lead to some prospective U.S. home buyers not getting a home mortgage.

Q: What about auto loan rates?

A: They would rise, as well. The average 48-month, new car loan rate of 4.15% would probably rise substantially, again in weeks, if not days.

Q: What about loans and credit for small businesses?

A: That's another area that would be affected by a Greece default. With the loan pool to small businesses still constrained by the Lehman Bros. collapse in 2008, banks and other line-of-credit providers many choose to reduce the pool of funds available/decrease credit lines and/or increase interest rates for small businesses. In some cases, that could amount to a small business not get the funding needed to do a promising business expansion.

Q: How did Greece get in to this mess in the first place?

A: As with most large economic and financial problems, the problem was a long time building, as they say in the South in the United States.

Greece has one of the most extensive social safety nets and generous public sector benefit plans in Europe, and in the developed world, for that matter. Those benefits, combined with inconsistent enforcement of its tax code, a low birth rate, and growth-constraining business regulations, among other factors, led to high public expenditures and insufficient revenues, which piled-up over more than two decades.

Further, like an individual citizen, a nation can take on only so much debt before lenders get nervous, and Greece reached that point about two years ago.

Q: But everyone is saying Greece is such a small country. Why will interest rates rise so much, if Greece is so small, in economic terms?

A: Although small, a Greek default would represent another wave of the financial crisis. In company terms, Greece is about one-third as big as Lehman Bros., and if you recall, the Lehman bankruptcy triggered the worst global financial crisis since the Great Depression.

What's more, although the U.S. and global credit markets have improved since the financial crisis' acute stage in the autumn 2008/winter 2009, they still haven't fully recovered from the first wave of the financial crisis, ushered in by Lehman.

As a result, although Greece is small, even a minor shock wave would rattle credit and stock markets. And that would push up interest rates, in the U.S., Europe, and in other regions of the world.

And there's another problem with a possible Greek default: contagion. Institutional investors (IIs) -- the financial world's big guns that include hedge funds, pension fund, and investment funds -- are always forward looking: i.e. they try to anticipate future events based on current events.

A Greek default would likely signal to these institutional investors that If Greece can default, other nations with large debt can default, as well. Who else has a lot of debt? Italy. Let's sell Italy's bonds.

In other words, a Greek default could spark unusual if not panic selling of Italy's debt -- driving up Italy's interest rates and probably racheting-up interest rates in Europe and the United States, even more.

Moreover, Italy's sovereign debt level is not insignificant: it has a public debt of about $2.8 trillion, or about 120 percent of GDP. To be sure, the Italy and Greek cases not identical -- Italy's economy is stronger than Greece's; nevertheless Italy probably would not be able to service its debt, if its interest rates rose on contagion triggered by a Greek default.

I.E. the global financial system is still vulnerable to an attack by the bond vigilantes.

Bond Vigilantes: Hit Bear Stearns, Lehman Bros. - Is Greece Next?

Economist Ed Yardeni, who now runs Yardeni Research Inc. of Great Neck, N.Y., coined the term 'bond vigilante' in the 1980s to describe the institutional investor practice of selling bonds and shorting bonds of governments when they see unsustainable fiscal policies and/or other actions by governments or companies that the institutional investors believe will lower the value of the bonds issued.

Of course, in the best of all possible worlds, the bond vigilantes would not panic, let alone attack. But we don't live in the best of all possible worlds, but in a very real, pragmatic one, in which institutional investors respond the way the typical parent would to word of a large outbreak of flu at their child's school.

If you learned of a flu outbreak, you might keep your kids home for a day or two, or await instructions from school officials concerning when it's safe for the kids to return to school.

Institutional investors have responded like that with Greece: Greece is the sight of a flu outbreak. It's not an epidemic, but it's pretty bad, so you're going to keep your kids (capital) home for a few days.

School officials (European leaders) are signaling that things are improving (Germany's Bundestag vote), and they appear to be, but just the same, you're going to wait a couple more days before allowing the kids to return to school.