Paving the way for QE3?

Things are not looking good on the housing front in the U.S. The latest figures show that prices slumped yet again in March, dragging the closely watched Case-Shiller index to its lowest point since the start of the downturn (see graph above).
Sure, there is still some distance to go before the housing bubble is completely burst, but any further drop in prices will be a drag on the economy as it widens the already dire "negative" equity situation for a large number of households.
Quantitative easing is a critical tool in maintaining a floor on housing prices because of its influence on the 10 year maturity yield. A large number of market participants including mortgages, pension funds and the good old dividend discount model (DDM) use it as a benchmark to set their rates. In other words, the latest housing price figures are likely to put additional pressure on the Fed to do something post QE2 which will end very soon.

Embracing for a restructuring?

Somewhere along the line, Greece and probably Ireland and Portugal are going to have to restructure their debt. It is almost inevitable because all other options that would effectively help avoid restructuring don't seem to work. Those "options" would be:

• A sharp rise in taxes, which will probably only lead to a further paralysis of the economy, especially given the chronic level of tax evasion in a number of the peripheral countries involved.
• A devaluation of the currency which unfortunately is no longer an option for the countries of the Euro-zone given that they no longer have this tool at their disposal.
• An internal form of devaluation which is effectively a sharp and sustained cut in wages across the board. As with a hike in taxes, such a move would be so deeply unpopular that it would provoke more riots that would plunge the respective economies into further turmoil.
• A sharp cut in fiscal expenditures or the infamous austerity measures. This is yet another "dead in the water" option as it is unlikely to resolve the debt problem on its own and would also contribute to weakening the other options such as tax income further.

Given the above, it becomes clearer that the only viable option would be some form of restructuring. But then again, there are different shades of restructuring to choose from and the outcome can be materially different depending on which one is selected. At one end of the spectrum is the more painful approach of applying a "haircut" which is effectively paying back a fraction of the original value of the debt. This would force the various banks to take losses by writing off a large amount of debt in their books. At the other end is a softer technique known as "reprofiling" which is effectively to extend the maturity of the bonds and by doing so, buy precious time for the troubled governments. This option, which seems to be the one favored by the core European countries, begs the question as to how exactly buying additional time would resolve the problem. Considering that the various alternative options are likely to be ineffective, the only effect of buying time will be to postpone the inevitable to a future date.

This brief analysis clearly suggests that restructuring is the only viable option at the table. The question to be asked is what form of restructuring will be applied and when will it take place.

How to tackle spiraling debt...

There are a couple of ways that a government can tackle a mounting debt problem.
If the debt itself is reasonable, and the economic conditions are stable, the method with the least repercussions is through growth. If the economy is expanding rapidly enough, the debt of the country should be very manageable. Austerity measures or cutting spending is another solution although, once again, it assumes that the debt is reasonable to start with.
But what happens when the debt is out of proportion relative to the gross domestic product of a country? The quick and dirty way of getting out of it is to simply default. The main problem with this solution is that the consequences are bound to be extremely damaging. Think Lehman's and multiply the effect a thousand times! A softer version of this is to restructure the debt by means of applying a haircut or just simply extending the maturity. That is, for example, what the markets are anticipating for Greece.
Another method is for a country to try to inflate itself out of the debt spiral. The idea is that by stimulating the economy, prices will begin to rise high enough to depreciate the value of the outstanding debt. The real value of that debt has actually changed since the lender is getting paid less in real terms than what was lent in the first place. The major drawback with this approach is that the impact of inflation goes beyond debt and is therefore bound to be politically unpopular.
A related method is the devaluation of the currency, a tool that is unfortunately unavailable to the peripheral nations in Europe who need it most. By devaluing the currency, foreign lenders get paid less in real terms, so technically it becomes cheaper for the borrow to service the debt. This is a very attractive proposition for the U.S. where the large bulk of debt is in the hands of foreign owners. It would explain why the Fed is in no hurry to tighten rates like the rest of the world is doing. Depreciation has its drawbacks too. It could trigger inflation by boosting demand for exports and spiking the price of imports.
Although the examples show that there are several ways a country can tackle its debt problems, it doesn't mean that they have access to all these methods. Eurozone countries are a case in point: By joining the Euro they gave up the very monetary tools that would have provided them with greater flexibility. Without these tools, they can't inflate themselves out of the debt and nor can they depreciate the currency. This leaves them with two possible solutions: hard core austerity (which doesn't seem to be working) and restructuring. It looks increasingly likely that some form of restructuring will eventually have to take place.