It's intimately connected with it because as the markets closed up and the global economy started coming to a halt, that hit the very small Greek economy directly. Its key sources of revenues are things like tourism and of course that was way down because of the global economic problems. At the same time, borrowing costs rose, lenders became much edgier about giving money to questionable borrowers and in the case of Greece, the Greek banks are heavily exposed in the Balkans -- they've been lending a lot of money to places like Albania, Macedonia and Serbia, and to do that, they'd been borrowing from bigger banks and Germany, France and elsewhere, and securing those loans with Greek government bonds as collateral. It's the same at the European Central Bank. If a bank needs overnight financing from the ECB, it puts up Greek government bonds as collateral. But the ECB is not allowed to accept any bonds that aren't investment grade, so if Greece's bonds are suddenly turned to junk by the rating agencies, the ECB is not allowed to accept that collateral, which means it can't give money to the Greek banks. So that's a major problem and a lot of that was precipitated by the initial financial crisis because once credit markets froze up, they just lost access to all kinds of potential funding that was available before at relatively low rates.
Remember that interest rates were very low, you could borrow really cheaply, and that enabled them to finance incredibly profligate spending. Some of it was required by Greek law, because they have a huge social safety net, bizarre contracts with public sector unions that enable them to get 14 months salary for 12 months work, huge pensions, as the economy slowed down they were faced with much higher unemployment costs and all the things that go with it. We've seen it in North America, the U.S. and Canada had to take on huge deficits to cover amazing problems in the financial system but also in their economies. The Greeks did the same thing on a smaller scale, but they had no money to do it.
What are junk bonds?
It's a wonderful term that came out of the late 1980s when Michael Milken created what's known as the junk bond market. These are just bonds rated below investment grade, which means they have a higher risk than bonds where you're more confident of the future of the issuer. Once that happens, and in fact it happens before they get downgraded to junk, when they're on the edge of it, a lot of institutions aren't allowed to own them. Major pension funds cannot own high risk bonds for the most part. The big pension funds we know have to have investment grade bonds to balance out their riskier equity investments and other things like that. So as long as Greece had an investment grade bond with a nice yield, the Scottish widows and orphans fund, for example, could buy it. When it's junk, they can't touch it and they're required to sell it, which makes the problems even worse because you have to have more of this stuff on the market, you have yields rising to exorbitant levels because investors need to be rewarded for the high risk, the market shrinks, in this case the Greek government can't issue new bonds because it's impossible, the market won't accept them and the Greeks desperately need a handout from the IMF and their colleagues in the euro zone.
We've heard recently about ratings agencies like S&P and Moody's downgrading other countries such as Spain. What does that mean when a country gets downgraded?
It means they're no longer as comfortable with the country's debt ratio. The things they measure are the ability of a borrower to repay the bond. That means that they look at things like revenue sources, economic prospects, debt-to-GDP levels, which are an important indicator, budget deficits, future costs and future prospects for increasing revenue, i.e. can they raise taxes if they have to, is there an opportunity to make cuts in fiscal spending. Those are the things they're supposed to evaluate on a regular basis and the ratings are supposed to reflect their view of the prospects of a borrower to repay, so when they make a cut of any serious amount, (i.e. a cut from triple-a to triple-a-minus is not a major cut -- that just means they're a little more leery than they were before), but if they go down a whole letter, from A to B, which happened in the Greek case, that's a serious cut, that means they're convinced the borrower is no longer as capable of repaying the debt as they thought. It doesn't mean they won't pay, or that they're about to default, but it means there's a higher risk of default and you as a lender need to be aware of these things.