Are Dubai's Dark Clouds Speading?

(MoneyWatch)  A few weeks ago Dubai went public with its debt troubles, and now we're seeing problems popping up with other sovereign debtors.

Consider what has happened in the last week or so:

• Standard & Poor's Ratings Service changed its outlook on Spain's credit rating to negative.
• S&P reduced Portugal's outlook to negative.
• Greece's credit rating was slashed by Fitch.
• Moody's indicated the United Kingdom and the U.S. better tighten their belts or they may be in for an adjustment to their top ratings.
• The Wall Street Journal reported that Moody's downgraded certain credit enhancement programs that resulted in downgrades to bonds issued by the cities of Chicago and New York.

Bad Trend. One might say there's a bit of a trend developing here in the public debt markets. Investors are reassessing the risks of government debt, and that could spell trouble for the fragile global economy.

As public entities experience credit downgrades or doubts about their credit ratings, the cost of borrowing will likely rise. Just like with individuals, if a government has bad credit, it will have to pay more interest to borrow money, and may not be able to borrow as much as it needs. That could put some governments in a credit squeeze, similar to what happens to families who borrow too much and then get cut-off by skittish lenders.

Remember, the crisis started in the credit markets with sub-prime mortgages, and over the last two years it has slowly spread to other parts of the lending markets, like prime mortgages, commercial banks, investment banks, small businesses and now sovereign debt. That's not a good pattern. And at each turn, the problems have been deeper and more complex than anticipated.

Hedge Funds. It's also important to note that there are large investors (hedge funds) that are betting tons of money on more credit problems to come. These investors have a vested interest in making sure the world knows about any real or perceived problems with sovereign debtors. Basically, they could make a killing if certain government bond values fall, so they're happy to get all the data out there for the public to see.

In many ways, these investors impose a certain amount of crude discipline on government borrowers. If the government doesn't get its act together, investors will punish the entity by crushing its bonds. That's not a good way to deal with the problems, but markets have their own form of justice.

Bottom line. Keep your eye on these government debt issues. If the pressure keeps building, we could be in for another rough ride.

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