soverign debt

8/8/2019 Soverign Debt

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Part 1: How Large is the Outstanding Value of Sovereign Bonds?

Part 2.How Often Have Sovereign Countries Defaulted in the Past?

Part 2B: More on Historic Sovereign Default Research

Part 3.What are the Market Estimates of the Probabilities of Default?

Part 4.What are Total Estimated Losses on Sovereign Bonds Due to Default?

Part 5A.What Happens If Things Go Really Badly? $15 Trillion of Sovereign Debt in Default

Part 5B.Part 5B. What Happens If Things Go Really Badly? More Things Can Go Badly: Credit Default Swaps, Interest Swapsand Options, Foreign Exchange

Part 5C. Some Policy Options, Good and Bad

Part 5D. European Banks, What if Things Go Really Badly?

How Large is the Outstanding Value of Sovereign Bonds?


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Debt issued by governments worldwide is immense. According to the Bank for InternationalSettlements, at year end 2009 worldwide sovereign debt exceeded $34 trillion, and isgreater than the amount of corporate bonds outstanding.

Japan and the US dwarf most other borrowers. Together they have about half of allsovereign debt worldwide. Still, 23 other countries have over $100 billion of debtoutstanding. The other 100+ countries worldwide have a total debt of about $1.4 trillion.

Click on graph for larger image in new window.Note: This graph shows the sovereign debt in December 2007 and December 2009.

Due to the recession and increased expenditures to rescue banking systems, totalsovereign debts grew by almost 30% in just two years. Sovereigns became the majority ofworldwide debt. Several countries doubled their debts from 2007 to 2009 (BISdata).Source: Bank for International Settlements (BIS)

*For the US, figures include public holdings of Treasuries, but not Fannie Mae or FreddieMac (about $8.1 trillion year end 2009, per BIS), or the intragovernmental holdings ofSocial Security, Medicare, the Civil Service Retirement Fund, e tc. (about $4.5 trillion yearend 2009, per US Bureau of Public Debt).


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When shown as a percent of GDP, the picture looks a bit different. Japan and Italy haveboth a large amount of debt in absolute terms, and as a % of GDP.

The United States has a more moderate debt as a % of GDP.The third graph shows thesize of sovereign debt compared to equities and other bonds.

Because of its immense size, sovereign debt is one of the largest risks to the globalfinancial system. There are many linkages to sovereign debt, including interest rates,exchange rates, bank debt, and credit default swaps. Many of the potential problems andrisks are surprising, even to those well-versed in their particular area of finance.

Part 2. How Often Have Sovereign Countries Defaulted in the Past?


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Sovereign bonds have been defaulting for almost as long as there have been sovereignbonds. The problems go back many centuries. A good overview created for the IMF is TheCosts of Sovereign Default by Eduardo Borensztein and UgoPanizza. Some countries areserial defaulters, with a long history of sovereign defaults. Many have defaulted onsovereign debt five times or more.

Here is a chart showing the number of countries defaulting each year from 1824 to 2003.The raw data comes from S&P. Charts were created by the Some Investor Guy.

As you can see, there are some years with no defaults at all, and other years with many.Defaults tend to come in clusters, and the behavior of lenders often changes substantiallyafter defaults. In the Volatility Machine, Michael Pettis asserts that sovereign defaultcontagion follows predictable patterns, and that contagion is primarily due to investo rs inthe first defaulting country also having investments in other countries which are vulnerable.This is especially the case with leveraged investors.

In the seemingly quiet period from 1945 to 1959, there was just one sovereign default.

Interestingly, this was also a time with a number of very angry foreign investors. This timeperiod was the peak of expropriation of foreign assets. There were at least 25nationalizations and expropriations of foreign assets. Many were by new members of theSoviet Bloc, and by newly independent colonies (Source: Michael Tomz, Stanford, workingpaper).

For you ubernerds who want to see which countries defaulted each year, here they are.Ive broken them down into three periods to make the charts more readable.

1820 to 1920(click on chart for larger image)


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1920 to 1980

1981 to 2003


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The underlying causes of default (such as rises in interest rates, wars, commodity pricecollapses, and simply borrowing too much money) have been diagnosed for many episodes.Proximate to the default, any of the following six financial changes might occur:

1. Government revenues fall far below history or forecast;2. Expenses aside from debt service rise far above history or forecast;

3. Interest rates rise substantially; due to inflation, credit spreads, illiquidity, or other causes4. Demand for bonds suddenly drops or disappears (a sudden stop);5. Exchange rates move, making payments on foreign denominated bonds much moreexpensive (currency risk), and,6. A government simply decides not to pay, even though it has the capacity to pay(repudiation).

Paolo Manasse and NourielRoubini studied sovereign default risk and concluded that manyguidelines used for estimating when default was likely did not perform well, primarilybecause those guidelines looked at separate risks. For example, total government debtexceeding 200% of GDP is often used to indicate stress. However, some othercircumstances may make the problems much less severe (like having a growing economyand no foreign denominated debt). Other factors might make it much worse (like highinflation).

Part 2B: More on Historic Sovereign Default Research

Some researchers, especially Reinhart and Rogoff, assert that this time is not different,and that rather similar things occur before and after defaults throughout the world and overa period of many centuries. Politicians might or might not know the his tory. However, onewonders to what extent bond traders and CDS market participants agree with the


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Chart source Predicting Sovereign Debt Crises, page 30. For specific countries, defaultprobabilities from this model could be updated as often as the relevant economic data areupdated.

In the earlier paper for the IMF, they found (Predicting Sovereign Debt Crises, PaoloManasse, NourielRoubini, and Axel Schimmelpfennig):

The empirical evidence suggests that a number of macroeconomic factors predict a debtcrisis and the entry into a debt crisis. Measures of debt solvency matter: high levels offoreign debt (relative to a measure of the ability to pay, such as GDP) increase theprobability of a default and entry into default. Measures of illiquidity, particularly short -termdebt (relative to foreign reserves), and measures of debt servicing obligations also matterin predicting debt crises, consistent with the view that some recent crises had to do withilliquidity and/or the interaction of illiquidity and insolvency.

Other macroeconomic variables suggested from the analytical literature on debtsustainability also significantly matter for predicting debt crises: low GDP growth; currentaccount imbalances; low trade openness; tight liquidity and monetary conditions in theGroup of seven countries; monetary mismanagement (in the form of high inflation); polic yuncertainty (in the form of high volatility of inflation); and political uncertainty leading toeconomic uncertainty (years of presidential elections).

Another line of research comes from Carmen Reinhart and Kenneth Rogoff. They haveseveral relevant works, including This Time is Different: Eight Centuries of Financial Crises .


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We find that serial default is a nearly universal phenomenon as countries struggle t otransform themselves from emerging markets to advanced economies. Major defaultepisodes are typically spaced some years (or decades) apart, creating an illusion that thistime is different among policymakers and investors. A recent example of the thi s time isdifferent syndrome is the false belief that domestic debt is a novel feature of the modernfinancial landscape. We also confirm that crises frequently emanate from the financialcenters with transmission through interest rate shocks and commodit y price collapses.

Eight Centuries of Financial Crises also contains quite a bit of data on inflation, which theauthors view as a second way to default (if the bonds are denominated in the issuersnative currency), and exchange rate problems.

Historically, we will see that the average percent of sovereigns in default or restructuringhave sometimes been quite large (source: Eight Centuries of Financial Crises, page 4).

Rogoff also has analysis of what happens with high debt levels when there is not default.Some readers will enjoy their paper from early 2008, Is the 2007 U.S. Sub-Prime FinancialCrisis So Different?

We will revisit both sets of authors when looking at the indirect effects of default later inthe series. Numerous posters have mentioned Rogoff research showing a possible dropoffin growth above a threshold of 90% debt to GDP (CR Note: this level is disputed).

Part 3. What are the Market Estimates of the Probabilities of Default?

There are a number of ways of looking at chances of default and/or expected losses,including: bond yields vs a low or no default bond in the same currency, credit defaultswap prices, bond ratings, and analysis of underlying financial factors.


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Bond ratings move more slowly than bond yields or CDS prices. Ratings often are loweredonly after a major problem has been realized and is already incorporated into yields orCDS prices. While bond prices can be useful, there are an assortment of problems oftrying to extract default probabilities. One is the yield curve, and that for many sovereignsthere arent all that many maturities outstanding. Trying to get a 5 year probability ofdefault from a dataset including only a 2 year and 20 year maturity presents s ome analyticproblems. Bond prices also have a surprising amount of differences due solely to liquidity.

For example see Longstaff.

We find a large liquidity premium in Treasury bonds, which can be more than fifteenpercent of the value of some Treasury bonds. This liquidity premium is related to changesin consumer confidence, the amount of Treasury debt available to investors, and flows intoequity and money market mutual funds. This suggests that the popularity of Treasury bondsdirectly affects their value.

Yes, thats 15 percent between different US Treasuries and a series of bonds explicitlyguaranteed by the US govt, the 1990s Resolution Trust. Even o n the run and off the runUS treasuries have different yields due to liquidity.

Because it provides daily information for almost all large sovereigns, and calculatescumulative probabilities of default (CPD), we use data from CMAVision to estimatesovereign default probabilities.

This chart shows outstanding debt with the (CPD) for each country. Despite it having amoderate 8.3% probability of default, Japans huge outstanding bond portfolio makes it thelargest contributor to expected sovereign losses . However, its unlikely that any countrywould only have a default on a small group of bonds. If Japan defaulted, it is likely thatmost or all of its outstanding debt would be restructured (e.g., different interest rate,extended payment, a haircut on pr incipal).

CPDs from 3/31/10 and 6/30/10 are shown in the next chart. The red bars are Q2, theorange bars are from Q1. Obviously, some credit default swap prices moved substantially in


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those three months, like Greece, Portugal, Spain and Belgium.

As of June 30, 2010, the weighted average expected default rate is 7.4%. When weightedby value of debt outstanding, CDS pricing worldwide points to 7.4% of it defaulting within 5years. If the outstanding sovereign debt was still $34 trillion as reported at 12/31/09, thats

$2.5 trillion of defaulted debt. If the trend of increased borrowing has continued to $36trillion at 6/30/10, its about $2.7 trillion of defaulted debt.

Before you run out and start shorting sovereigns or panic over your retirement, rememberthat bondholders seldom lose all of their money on defaulted bonds. Sometimes recoveryrates are quite good. Others, not so much.

Part 4. What are Total Estimated Losses on Sovereign Bonds Due to Default?

In Part 3, we showed that credit default swaps imply that 7.4% of sovereign debt willdefault over the next 5 years. However, the defaulted bonds probably would not lose all oftheir value.

In some cases, losses given default are quite small, a few percent. In some restructurings,only the durations are changed, and a technical default might not result in an actual loss.At the opposite end of the spectrum, losses on a particular bond could b e 100%,especially if a sovereign had junior or subordinate debt.


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To estimate losses, in addition to the Probability of Default, we need to estimate RecoveryRates Given Default.

Moodys has studied sovereign default recoveries in the past several decade s(Source:Sovereign Default and Recovery Rates, 1983 -2008). Recovery rates have rangedfrom 18% (Russia, 1998) to 95% (Dominican Republic, 2005), when measured on all debt

from a particular sovereign at the time of default. The average recovery rate was 50%when each country was weighted equally, but only 31% when weighted by the face valueof all outstanding bonds from all defaulting issuers.

Applying those recovery rates leads to expected losses of $1.3 to 1.8 trillion, or about 3.7- 5.1% of outstanding sovereign debt at 12/31/09, and about $100 billion more at 6/30/10.We now have our baseline estimate of worldwide sovereign default losses.

This might not sound too bad, unless you happen to live in one of the defaulted countries,or own a lot of that countrys bonds.

Even at the baseline $1.3 to $1.8 trillion, those losses would be about the size of alloutstanding debt of China, Germany, or France. And, default losses arent the only losseswhich could be occurring in your bond portfolio. For example, if Greek bonds default, Irishinterest rates might go up substantially, and Ireland might m erely be in pain rather than indefault. In that case, if you purchased Irish bonds before the crisis, their market valuemight drop substantially below what you paid. Hopefully you didnt buy them using leverage.If the bonds arent denominated in your na tive currency, you could be experiencing largeFX losses.

Ubernerd warning. This part of the post contains pictures, but is also pretty technical .

Some posters have asked, why not use the CDS prices themselves, which containinformation on both the default probabilities and expected recoveries? Well, if the two areseparated, you are able to do certain things in modeling that are impossible to calculatewith them jumbled together. It is easier to compare to historic data which often tracks theoccurrence of default, but not the recovery. It allows you to do frequency-severity

simulations.

For you ubernerds, it also means that you can model and correlate frequency and severityseparately. Would you change your estimate of severity of loss on Greek bonds if youthought Spain and Italy would also default? Do you think that the probability of defaultgoes up each time debt needs to be rolled over, but the recoveries given default wontmove much? Then the common assumption of 40% recovery rate doesnt work with yourmodel.


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Here is a chart derived from a large banks presentation on sovereign CDS modeling whichshows just how different your cumulative probability of default could be for a sovereign likeGreece which closed at 811 basis points yesterday (Ju ly 13, 2010). The differences getpretty big, pretty fast. Ive used the same historic range of 18% to 95% recovery rates toillustrate this. Its pretty obvious that the CDS market doesnt expect 95% recoveries fromGreece. However, there are many combina tions of probability of default and recovery ratewhich are consistent with current pricing.

For those of you who followed the subprime crisis closely, some common CDS modelingassumptions may sound familiar. My favorite misnomer is discount cashflows at the risk-

free rate. There IS no truly riskfree rate. (CR note: by "riskfree", usually people meanessentially default risk free like U.S. treasuries. "Some investor guy" is pointing out there isstill interest rate risk).

There might be interest rates on a security incredibly unlikely to default. However, interestrates on that security will still move around, introducing plenty of risk which has nothing todo with default. Do you think that commonly used riskfree rates like 30 day LIBOR or 90day US Treasuries might fluctuate and diverge in a crisis? Like they did in 2008 and 2009?


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CDS Price Correlation (chart 2)

There appears to be another market behavior which you might not expect unless you hadseen it before: very strong correlations of securities which dont appear to have the sameunderlying risks. Take a look at these charts on CDS prices for example. These may beartifacts of how people are funding, leveraging, or hedging their positions.

CDS Price Correlation (chart 3)


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The short term correlations are so strong that only events like Hungarys whoops, wedidnt really mean that event stand out.

Source: CMA Sovereign Risk Report for Q2 2010

The strong correlations arent just in prices, those correlations also occur in trading volume.(see chart 4 below) It would not be surprising to find correlation desks at major traders

generating lots of this volume. Who is trading, why, and how, are important in guessingwhat might happen if things go really badly.

Source: CMA CDS Liquidity Study

Part 5A. What Happens If Things Go Really Badly? $15 Trillion of Sovereign Debt in Default


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In order to keep the Really Bad scenario from becoming massively long, its in severalpieces. This one is only on sovereign defaults. There will be more on swaps and banki nglater in the week.

How likely or unlikely is the Really Bad scenario?

The author has built a number of risk simulation models for various purposes. Choosingscenarios or simulation outputs which show things going really badly involves sometradeoffs. There is always that small probability of Earth being hit by a huge asteroidresulting in mass extinction. I usually leave such events out of my models. Wars anddisease are tough items to model, but government financial problems are often relat ed.More on those in Part 6.

There is a strong tendency among people who are not researchers or modelers to think aparticular bad scenario cant or wont occur. If you want to get attention from managementor regulators and motivate them to do something, one effective technique is to show whatwould happen if something very similar to prior history repeated itself. When they saytheres no way that many sovereigns could default at once, you pull out the numbers andshow them that its actually occurred several times in the past.

People who dont do statistics are usually drawn to individual stories or scenarios. I look forscenarios which are informative about risks that might be mitigated in some way. Itsfrustrating for everyone involved if they be lieve what you are presenting, but then cant doanything about the risks or other problems.

So, out of the multitude of potential scenarios, I have settled upon one which is really bad,but doesnt involve asteroids, mass extinctions, or apes taking over . It is consistent withprior bad episodes of sovereign debt default.

Here is the Really Bad scenario. Its not a worst possible scenario. It is more like the LongDepression or the Great Depression reoccurring under 2010 conditions.

In the Really Bad scenario, 45% of the countries with large outstanding sovereign debtsare in default within a 2-3 year period.


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Click on graph for larger image in new window.

As we saw in Part 2B, levels between 40% and 50% of sovereigns in default have beenreached five times in the last two centuries, (1830s, 1840s, 1880s, 1930s, 1940s, source:Eight Centuries of Financial Crises, page 4).

So, who defaults? A simple method is to choose the 45% of countries with large sovereigndebts (over $50 billion) that currently have the highest cumulative probability of default.They are assumed to default in the same order as implied by their cumulative probability ofdefault at 6/30/10 from CMA: Greece, Argentina (again), Portugal, Ireland, Spain, Italy,

Turkey, Indonesia, Belgium, South Africa, Thailand, South Korea, Poland, Brazil, Mexico andMalaysia.

This involves about $5.6 trillion of debt in default, about 16% of all soverei gn debt. Ifhistoric trends repeat themselves, it all happens within about two years of the first default(Greece), and 11 home currencies are involved. At the low end recovery rate of 31% offace value, there are about $3.8 trillion of losses. This is abo ut 2-3 times the amountcurrently embodied in credit default swap pricing which we calculated in Part 4 ($1.3 -1.8trillion).

But then, since this is a really bad scenario, Japan defaults too. This might occur becauseof a global economic slowdown, a rise in general risk premiums and interest rates raisingJapans debt service (this could take longer, Japans average maturity is 5 -6 years),Japans banking system being affected by defaults elsewhere in the world, lack of political

will to make reforms, or several other mechanisms.

For those of you who say Japans default is an incredibly unlikely event, note the following.Many officials have a long term concern about Japan. If there are many other sovereigndefaults, the time frame could speed up consider ably.

1. Prime Minister Naoto Kan said We cannot sustain public finance that overly relies onissuing bonds," Kan told parliament in his first policy speech. As we can see in the eurozone confusion that started from Greece, there is a risk of default if the growing publicdebt is neglected and if trust is lost in the bond market."


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2. In the last year, the price of Japanese CDS have tripled. CMAVision estimates a 5 yearprobability of default of 8.3% from their CDS prices at June 30, 2010.

3. Japan has the highest debt to GDP ratio of any developed country. It is expected toreach 225% of GDP in 2010 (Source: The Outlook for Financing Japans Public Debt, IMF2010)

4. Japan is in danger of a slow motion sovereign debt crisis 5 to 10 years fromnow,warns Kenneth Rogoff, professor of public pol icy & economics at Harvard University.

5. The IMF modeled the effect of sovereign defaults elsewhere on Japan. They foundSovereign debt crisis and increased risk premium. Assessing the macroeconomicimplications of a sharp rise in government bond yiel ds, this scenario assumes an increasein the risk premium by 100 basis points for the U.S. and 200 basis points for the euroarea without offsetting fiscal policy. If the risk premium in Japan remains unaffected,growth would slow through the export and exchange rate channel by between 0.5 to 1percentage points in 2010. If, on the other hand, the risk premium in Japan also increases(by 100 basis points), growth could fall by as much as 2 percentage points. Givendepressed demand, deflation would worsen by about 0.5to 1 percentage point below thebaseline in 2011. (source: IMF, Japan Staff Report for the 2010 Article IV Consultation,June 2010).

Japan has over a quarter of all sovereign debt outstanding worldwide. Its default would bebigger than all of the others in this scenario combined.

In ou

In our r Really Bad scenario, another $9.7 trillion in sovereign debt goes into default. Thetotal debt in default reaches $15.3 trillion, and almost half of all outstanding sovereign debtis in default. The losses are $10.5 trillion at the low end recovery rate of 31%.

At the low end, losses are $7.5 trillion (50% of face value). Of course, recoveries in some


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countries will be higher than others, but you get the general idea.

Part 5B. What Happens If Things Go Really Badly? More Things Can Go Badly: CreditDefault Swaps, Interest Swaps and Options, Foreign Exchange

In Part 5A, I showed a Really Bad scenario consistent with some very bad historic defaultrates for sovereign debt. That produced an estimate of $15.3 trillion of def aulted sovereigndebt, with $7.5 to $10.5 trillion of losses.

In todays post, we look at the effects of sovereign default on credit default swaps, interestrate swaps and options, and currency exchange contracts.


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Sovereign risk can make its way into over the counter markets in many ways, including:

A. For credit default swaps, the sovereigns are often the reference entity. In otherwords, market participants are often buying and selling insurance related to a potentialfuture default of a country on its debt.

B. Sovereign bonds are a major form of collateral for over the counter trades. Thecollateral itself is often marked to market. Thus, movements in interest rates often changesthe value of highly rated sovereign bonds posted as collate ral, and a participant might postmore or fewer bonds as collateral as a result. However, sovereign bonds are typicallysubject to larger haircuts if downgraded, and might not be accepted at all if rated lowerthan BB-.

C. Sovereigns ARE the participants in a large number of contracts. Yes, manygovernments and/or their central banks or sovereign wealth funds are active participants inOTC markets. The authors impression is that sovereign participation in the CDS market islow, but participation in interest rate and FX markets is considerably higher.

OTC markets are huge. Their notional values are over $600 trillion, and exceed all otherforms of investment combined (source: BIS Quarterly Review, June 2010 ). During the 2008crisis, the market values of CDS, interest rate derivatives, and FX contracts was about thesame as all outstanding sovereign debt, or all outstanding equities.

There are also exchange-traded interest and FX futures and options, about $67 trillion in2009 (source: BIS Quarterly Review, June 2010, page 126 ).

Unlike stocks and bonds, the total market values for the OTC rise during times of turmoil.Thats partly because when interest rates or FX move from their values when the contractswere entered into, one party to the transaction now has a positive mark to market valuefor the swap (the other counterparty has a negative mark to market value).


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From mid 2007 to the end of 2008, the market values of FX and interest rate derivativestripled, even though their notional values moved by less than 9%. The market value of CDSwent up by a factor of seven, on an almost unchanged notional value .

Credit Default Swaps.

The next chart shows the ratios of gross and net notional to current outstanding bonds.Unlike the case for many corporate borrowers, for sovereigns its rarely the case that evengross notional CDS values exceed sovereign bonds outstanding. Its even rarer for net


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notional to exceed outstanding sovereign bonds.

Good to know that CDS are unlikely to make sovereign default much worse, right? Well,these are recent CDS numbers, but take note. The ratios of CDS to bonds outsta nding arehigher for those countries believed to be in the most trouble. If sovereign financialconditions got much worse, the volume of CDS could go up considerably. In our ReallyBad scenario, I assume the amount of CDS outstanding on sovereigns triples, and about

half of it pays off. Currently there are about $2 trillion of sovereign CDS outstanding. Letsassume it goes to $6 trillion of notional, that half of that pays off due to the insolvency ofreference entity (the country the CDS is written on), o r $3 trillion. That produces $3 trillionof payments, but there is a lot of netting. Even with some counterparty problems, netlosses will probably not go over $1 trillion. Lets assume $500 billion to $1 trillion of netpayment and losses due to counterparty problems. Not too bad next to $7.5 to $10.5trillion of losses on defaulted bonds.

Interest Rate and FX Derivatives.

Here the situation is much different. The total notional value of OTC interest rate andderivatives is $500 trillion (half a quadril lion). It is many times the size of the sovereignbond market.

Interest rate and FX derivatives typically start out at inception with a zero market value.Over time, as interest rates move, a contract acquires a market value. Sometimes, thosemarket values are very large. In the 2008 distress, market values rose to $32 trillion from$11 trillion just 18 months before (Source: BIS, Table 19). Much of that market value iscollateralized. Much of it is not, especially for sovereigns.

During the 2008 market turmoil, all kinds of typical relationships between rates changed.Significantly, there were no sovereign defaults during that period. A sovereign default wouldhave made this period even more volatile.

During late 2008, huge amounts of collateral were s ucked into the over the countermarkets. With numerous sovereign defaults, this would likely happen again, probably on abigger scale. There are several major sovereign -related risks:

1. Sovereigns are frequently counterparties, and many of them typi cally dont post anycollateral. According to the ISDA Margin Survey 2010, exposures to sovereign governmentsand supra-national institutions tend to have the lowest collateralization levels. Only 25% ofwhat would normally be collateralized is collatera lized if the counterparty is a sovereign.Thus, a highly-rated sovereign, its central bank, or another quasi -sovereign entity couldaccumulate very large risk positions with no collateral. For example, a AAA -rated sovereignmight slide to lower ratings and eventually to default, leaving an immense amount ofcollateral and derivatives payments due.

Does that story sound familiar? Its what happened to AIG. AIG went from AAA rated inearly 2005 to being majority owned by the Federal Reserve in its first bail out in September2008.

AIG had some poor risk management decisions, aside from selling mostly unhedged creditdefault swap protection. ISDA asserts thatApparently, AIG relied excessively on a credit risk model that did not adequately accountfor both the sharp decline in the mortgage market and a downgrade of AIG's credit rating.It has been said that AIG would never have needed government assistance if not for itsinvestments in credit default swaps. Perhaps that is true. But it would be more accurate tostate that AIG would never have needed government assistance if had not so heavilyexposed itself to mortgage backed securities


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(ISDA,AIG and Credit Default Swaps, 2009 ).

Good to know that sovereigns dont provide unhedged credit guarantees, right? Amongmany other guarantees, it is common for sovereigns to guarantee bank deposits.

If interest rates or exchange rates moved quickly near the time a sovereign wasdowngraded or defaulted, a number of in-the-money swaps could be anywhere from

worrisome to worthless to the other counterparty. Cash is an acceptable form of collateral,so some sovereigns who control their own currencies might print money, though printingreally large amounts of it could have unintended consequences. Countries on the Eurodont have the choice of printing their own money. Often, the native currency is not theone the OTC contract is written in, so any money printed might have to be converted todollars, euros, or yen.

2. Sovereign bonds are a major form of collateral. As downgrades occur, haircutsbecome larger, meaning that for every $100 million of collateral required, a counterpartymight have to post $112 million of bonds with a BB rating. Then, when t he bonds gobelow BB- (typical Basel II collateral requirements), it wouldnt be acceptable at all.

3. Sovereign distress and default would likely cause a breakdown between hist oricrelationships and term structures. The relationships between short and long term rates in aparticular currency could move to a strong preference toward short term debt, with longterm rates going up. The relationships of interest rates in different c urrencies could moveconsiderably. In Part 5C on banks, well also discuss how LIBOR departed very substantiallyfrom its usual relationships in 2008, and in a period of distress this could easily happenagain.

4. Many interest rates for OTC contracts are directly set based on a sovereigninterest rate, or are strongly influenced by them. Thus, a contract between two banksmight be based on a rate which becomes very volatile, or unglued from its historicrelationship.

Having defaulted or distressed sovereigns as counterparties could cause cascading defaults.Downgrades of sovereign debt being used as collateral could cause a massive rush for

debt which is still highly rated, and cash. Remember that not only will traders have toreplace downgraded deb t with other collateral, downgraded debt will lose a big portion ofits value and is affect traders balance sheets, and the entire system will need much morecollateral.

Total Current OTC Collateral, Current Credit Risk

At year end 2009, there was only about $3.2 trillion of collateral posted, on over $600trillion of notional value contracts, ISDA Margin Survey 2010.

With $22 trillion of gross market value of derivatives at year end 2009, BIS shows grosscredit exposure of $3.7 trillion (Gross market values after taking into account legallyenforceable bilateral netting agreements), BIS Quarterly Review, June 2010Much of the halftrillion of uncollateralized exposure is sovereigns. While I have no reason to doubt the BIS

data collection on this item, the $3.7 number is not what it might seem to be.

Stress Cases

If you were to assume that there was only $3.7 trillion of credit exposure in the OTCderivatives market, you would be greatly underestimating.

Why? 1. The BIS number assumes that all expected netting actually occurs. These arebilateral contracts. It is not a given that netting will function properly w hen there are somebig defaulted counterparties and quickly rising collateral requirements. 2. The BIS number


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would be more appropriately titled gross credit exposure at current market values. Ifmarket values change wildly due to movements in interest rates and FX, the market valuesof the OTC contracts will rise considerably. Vastly more collateral and/or credit exposurewould now be booked at the new prices.

How much more collateral? Between mid 2007 and late 2008, the market value of OTCderivatives rose by $21 trillion (source: BIS). The gross credit exposure rose by $2 trillion.

A couple of analogies may help. If a bank looks at a line of credit for a borrower, it hastwo different risks. First, the risk that the borrower wont repay part of all of what theyhave currently borrowed. Second, the risk that they will borrow considerably more, evenmax out the credit line, and then not pay that amount. The second one is an extremestress case.

Another example is even more informative for OTC derivatives. Credit default swaps aresimilar to insurance in many ways. What many people miss is that interest rate and FXderivatives are also similar to insurance in many ways. They are much like the way thatproperty insurers transfer risk around between various companies. Writing homeownerscoverage in an area prone to hurricanes involves taking in risk. It is then sliced, diced,moved around in various ways, and mixed in with risk from other areas and hazards. Ofcourse, regulators do tests for adequacy of capital.

In an analysis which sounds like you could simply substitute financial crisis for hurricane,Rawle Kingwrote,as development increased in coastal areas, a catastrophi c hurricane could result in hugegovernment outlays for disaster assistance and present insurers with significant financialhazards, such as the risk of insolvency, a rapid reduction of earnings and statutory surplus,forced asset liquidation to meet cash needs, and ratings downgrade ... for the very highestlayers of catastrophe risk, the government (and consequently the taxpayer) is now, bydefault, the insurer of last resort.

Insurers were caught off-guard by the large losses associated with Hurricane Andrewbecause of significant errors in actuarial estimates of potential hurricane related losses.Prior to Hurricane Hugo in 1989, the insurance industry never suffered any loss over $1

billion from a single hurricane. Further, most insurance industry ex perts estimated theprobable maximum loss (PML) for a single hurricane in the United States at between $8and $10 billion, and that such an event would occur only once in a century. HurricaneAndrew took insurers and forecasters by total surprise. In hindsight, because of the lull inhurricane activity during the 1970s and 1980s, insurance policies were underpriced andinsurers accepted far more hurricane exposure than could be supported by their capitalresources (including reinsurance).

That was published several months before Hurricane Katrina.

The low hurricane period of the 1970s and 80s has a close analog in finance, with similarresults. The Great Moderation lasted from the late 1980s to 2007. In a speech in 2004,Fed Governor Ben Bernanke said

One of the most striking features of the economic landscape over the past twenty years orso has been a substantial decline in macroeconomic volatility ...

I have argued today that improved monetary policy has likely made an importantcontribution not only to the reduced volatility of inflation (which is not particularlycontroversial) but to the reduced volatility of output as well. Moreover, because a changein the monetary policy regime has pervasive effects, I have suggested that some of theeffects of improved monetary policies may have been misidentified as exogenous changesin economic structure or in the distribution of economic shocks. This conclusion on my pa rt


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makes me optimistic for the future, because I am confident that monetary policymakers willnot forget the lessons of the 1970s.

In the Really Bad scenario, we have passed the Great Moderation, and are currently sittingin the relative calm between Hurricane Hugo and the much larger Hurricane Andrew (3xHugo), or the even larger Hurricane Katrina (6x Hugo).

In our Really Bad scenario, there isnt enough collateral to cover the gross marketvalues. If collateral was required on all positions of all traders and the market valuesreached 3x their 2008 values, gross market value would be about $100 trillion dollars. Thatwould exceed all sovereign debt, all corporate debt and all outstanding equities. However,even in a dysfunctional market, there is a lot of netting.

There might not be enough collateral even if netting. In recent years, the ratio of grosscredit exposure to gross market value has been about 14-22% (BIS data). Lets say thatthere is a need for a maximum of $20 trillion of collatera l given the net positions. Whilethere is probably enough collateral worldwide to cover $20 trillion, it would undoubtedlymove market prices for acceptable assets. It would also be difficult to buy or borrow thatmuch in a short time period.

Its not just collateral. During a crisis, huge amounts of money would be changing hands.Many interest rate and FX contracts would have their scheduled payments.

An estimate of OTC losses.

While this is not a market value estimate like Part 5A, in the Really Bad scenario, defaultedsovereigns, banks, and other counterparties might find themselves unable to make asubstantial part of their payments, or provide collateral. The IMF has discussed thesystemic risk associated with cascading counterparty failures in Making Over-the-CounterDerivatives Safer.

Despite some large efforts by academics, governments, and others to estimate stress caselosses, there are a myriad of modeling issues and choices. For the Really Bad scenario, Iuse a similar assumption to the losses on sovereign bonds. 45% of the counterparties have

problems providing collateral or making their derivative payments as due. Losses to theircounterparties are 50-69% of what is owed. That results in another $4.5 to $9.0 trillion oflosses on interest rates and FX, and $0.5 to 1.0 trillion on CDS. So far, were at $12.5 to20.5 trillion of losses in the Really Bad scenario

Such large losses require that in addition to the sovereigns themselves, a number of largeOTC traders would default. The largest traders include banks and other institutions whichhave already received government rescues or substantial additional capital fromgovernments. The Really Bad scenario assumes that solvent governments do not cover, orcannot cover, many of those traders OTC losses. NourielRoubini andMichaelPettis haveinteresting views on this. Due to OTC losses and direct losses on sovereign bonds, in ourReally Bad scenario many of those firms would be in bankruptcy, conservatorship,receivership, or liquidation. As a result, massive changes would occur in the OTC market,and financial systems as a whole.

What can be done? Can we just print money? Turn unacceptable collateral into acceptable?Issue IOUs? Can governments change the terms of the OTC contracts? How aboutausterity, would that help?

Full Disclosure: Some Investor Guy owns no credit default swaps, interest rate derivatives,or FX contracts. This series is not investment advice nor an offer to buy or sell anything.Unless cited to other sources, opinions are the authors. Like jus t about any other analyst,he could be wrong. He might be right, but he is not psychic. He is not a regulator, nor is


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he running for any elected office. If a regulator or researcher wants to talk about theseries, email CR. He will forward it to Some Investor Guy.

Sovereign Debt Part 5C. Some Policy Options, Good and Bad

Financial institutions, governments, and central banks can be creative in a crisis. Policyoptions fall into three broad groups: options for deeply distressed or defaulted sovereigns;options for creditors; and regulatory policies. In this part, we discuss the first two.Regulatory options will come in a later part.

To some extent, weve seen something similar to the Really Bad sovereign default situationbefore in the 2008 crisis. There have also been several episodes of very bad sovereigndefault over the past 200 years.

In our Really Bad scenario, about half of the sovereign debt is in default, and more wouldbe downgraded so that it isnt useful as collateral in many circumstances. In 2008, centralbanks from many countries provided cash and guarantees to help with the crisis. Whathappens when many of those governments and central banks are themselves in trouble?That too has happened before, coincidentally often shortly after banking crises.

Click on graph for larger image in new window.

Source: Banking Crises: An Equal Opportunity Menace, Reinhart and Rogoff .

The authors claim that

Banking crises dramatically weaken fiscal positions in both groups, with governmentrevenues invariably contracting, and fiscal expenditures often expanding sharply. Threeyears after a financial crisis central government debt increases, on average, by ab out 86percent. Thus the fiscal burden of banking crisis extends far beyond the commonly citedcost of the bailouts.


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Options for Distressed or Defaulted Sovereigns . What will sovereigns do? Some of the morecommon or reasonable options which are available to sovereigns who are in distress or athigh risk of default include:

1. Dialing for Dollars (or Euros, Yen, or other currencies). Just like a college student whois out of money, many countries will call their friends, relatives, and business associates .They will be looking for gifts, subsidies, loans, guarantees, and cosigners. Sometimes,

having a big letter of credit and some liquidity buys enough time to actually fix things.

Greece called the EU and the IMF for help. We will probably see more of th at from othercountries. Many people are surprised to find that usually most of the loan commitmentsmade by the IMF are not drawn upon.

2. The most common option, for those in or near default is to negotiate with creditors.This could involve combinations of reducing principal, extending maturity, and reducinginterest rates. For some sovereigns, there might be new debt in a different currency, likeDrachma, or Lira instead of Euros. For an interesting and detailed overview of options forGreece, see How to Restructure Greek Debt, by Buchheit and Gulati.

3. Print money to pay debts. Not all countries can do this. Members of the euro cantunilaterally print money. Greece cant just print its own money. Japan can. A large numberof countries can print their own money, but most of their debt is in d ollars or euros. Forexample, many eastern European countries can print, but have debts in euros.

If they print, they have to convert that money to another currency. Historically, inflation hasnot generally been a method of preventing defaults, but a s often occurred at the sametime or shortly afterward. (chart source: This Time is Different: A Panoramic View of EightCenturies of Financial Crises , Reinhart &Rogoff).

4. Print money, sell assets, or borrow from others to buy back your debts at a largediscount. No need to default.


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Usually governments try to calm bond market fears to keep their borrowing costs low.However, if many owners of your debt are very worried, are scrambling for cash, or arewilling to part with bonds priced at 50 cents on the dollar, it is the authors opinion thatyou should strongly consider taking the deal. Those are likely to be medium to long termbonds, and you could cut your debt service substantially for years, or even decades.

Ford did a version of this in 2009 and paid less than half of face value. Here is

anoverview. Fabulous idea in the right circumstances (even though one of the ratingagencies completely missed the point and thought it was equivalent to selective default,they clued in later). The hard part of doing this is usually finding enough cash to buy backdebt at a deep discount. Ford had plenty of cash, always a good thing to have in acrisis.

If you happen to be a government with some very marketable assets lying around (e.g.,gold, oil, a pile of hard currency in a sovereign wealth fund) and you are not in default,this could work out quite well. Brazil is a country that has successfully done this, andgotten a rating upgrade.

Governments with no distress have also bought back bonds. In 2000, the US Treasury wasrunning a surplus (remember that? Seems so long ago), and bought back billions in 30year bonds.

5. Austerity. Austerity is often useful for countries in moderate distress, especially if theycould balance their budget with debt restructuring. For countries who have alreadydefaulted, austerity is commonly part of emerging from default. Austerity is not useful if lotof money is required quickly. That could easily happen when maturing debt needs to berolled over, and no one wants to buy it.

It could also happen on interest rate or FX derivatives. In a crisis, swap payments and/orcollateral could be rising quickly, and would be due on short time horizons. A few monthsat the most, and sometimes a few hours.

And there are some slightly edgier options. Some of these might be fully justified in certaincircumstances. Others might just be ways of disguising default, seizure, or stupidity.

6. Default only on the foreign debt. It is common for a country to issue multiple types ofdebt, often with one class of debt mostly owned by residents, and another class mostlyowned by foreigners.


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Domestic financial interests, voters, and even graffiti taggers often understand thedifference, and often put pressure on governments to stick it to the foreign investors.Oddly, the opposite often occurs, with domestic debt being devalued along with thedomestic currency, and foreign debt remaining in dollars or euros.


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Photo source.

7. Seize assets. Why would a debtor seize assets? Three common answers: because theycan; because they feel they have to; or because they fee l they have been wronged. Oneexample is Argentina in 2001, which expropriated $3.1 billion of pension assets in exchangefor Treasury notes in Dec 2001, and then defaulted anyway in Jan 2002. This chart showsa timeline of how things went wrong.

8. Claim fraud and try not to pay, especially for OTC derivatives. The possible rationalesare endless. An example case from Italy is here. Prosecutor Robledo alleges the Londonunits of the four banks misled Milan on the economic advantage of a financing packagethat included the swaps and earned 101 million euros in hidden fees.

He also claims the banks violated U.K. securities rules by f ailing to inform Milan in writingthat for the swap deal the city was a counterparty to the lenders rather than a customer.Banks abiding by the rules of the Financial Services Authority are required to shieldcustomers from conflicts of interest and provide them with clear and fair information thatisnt misleading. The prosecutor seized assets from the banks equal to their share of thealleged profit.

9. Claim that contracts were invalid in the first place . An example of this isIceland,Icelands lenders may lose as much as $4.3 billion, equivalent to a third of the economy,

after a court last month found that some foreign loans were illegal. There may also besovereigns claiming that some official was not authorized to enter into particular loans orderivatives.

10. Claim the people who entered into certain contracts were trying to cause default ordistress for thesovereign. Germany made this illegal earlier this year.

11. Depose, subpoena, or even arrest some of the counterparties. A number of countries


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have rather different legal traditions than the US, the EU, or Japan, and lots of their jailsarent up to Western standards either. Your typical counterparty doesnt have these kinds ofpowers. Once a regulator or prosecutor starts digging, they might find nothing. Or, theymight find something extremely damaging. Even charges unrelated to cheating a sovereigncould carry some serious jail time, like bid-rigging, money laundering, or tax evasion.

There are also some recent examples of central bankers or bank CEOs being arrested,

which might affect whether the sovereigns would honor contracts they entered into (KosovoCentral Banker, Nigerian banks and customers, multibillion forged claims on UAE CentralBank on two separate occasions). Here, here and here.

12. Cut loose sovereign wealth funds, quasi national organizations, and other borrowers orCDS participants which are separate legal entities. Depen ding on moral obligations orimplied guarantees is always risky. Investors in Fannie Mae and Freddie Mac bonds wontheir bets that the US government would step in. This will not necessarily be the caseelsewhere.

13. And of course, do positive spin, even lie about financial condition. If a governmentwants to cheat, it can cheat, said Garry Schinasi, a veteran of the International MonetaryFunds capital markets surveillance unit, which monitors vulnerability in global capitalmarkets. Source.

Options for Creditors. For creditors, there are some interesting options. Common onesinclude:

1. Reduce trade credit, try to get trade sanctions. These are very common measures.

2. Press for higher taxes, business-friendly regulations, austerity. These are straight out ofthe traditional IMF playbook (now slightly modified).

3. Get your government to bail you out, perhaps by buying defaulted bonds above marketprice. Another possibility for partial recovery is getting changes to the tax code, such asallowing losses to be carried back, or offset against other forms of income.

4. Seize local assets. There is a long history of this, and sovereigns with extensive foreignassets could be at risk. Recently there was an unsuccessful suit by a creditor to seizeassets of Argentina held in the US to compensate for defaulted Argentina bonds.

Somewhat rarer approaches include:

5. Convince your own government to sail gunboats into the harbor of the capital. Selltickets to the news media. Venezuela in 1913 was a prominent example. Two discussionsof how prevalent this method of collection once was or wasnt areat here and here. This hasbeen rare to nonexistent since World War I. However, looking at the earlier experience, itwould be a bad idea to already have major military powers upset at you and default onyour bonds. Killing or kidnapping foreign citizens was espe cially likely to get a response.Having large oil or mineral reserves might also make a country a target.

6. Turn the borrower into part of another country. Yes, there are sometimes sovereignconsolidations due to finances. This happens more often at the municipal level, but in theearly 1930s Newfoundland went from semi -independent status to being part of Canada.Much of the reason was Canadas willingness to pay most of Newfoundlands debt. Moredetails here. While this might occur somewhere at the country level in the Really Badscenario, its more likely to happen with municipalities, provinces, or states.

Disclosures: At a prior job Some Investor Guy had a number of automakers as cli ents. Heowns some Ford bonds, some other corporate bonds, and some municipals. He owns no


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foreign sovereigns, because he is expecting prices to fall and yields to rise on many ofthem. He owns no gold, has very little in equities, some real estate, and a lot of cash.Make your own decisions on what your portfolio should be. This is disclosure, notinvestment advice. Some Investor Guy has no remote doomstead or bomb shelters, butthinks everyone should have a weeks worth of water and food. There are plenty ofdisasters where those could be useful. He does sometimes talk to regulators andlawmakers.

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