Eli Dourado

Thoughts on sovereign default

My new favorite website is this one, which monitors credit default swaps and displays some useful free data about them (you can pay to get more data). The most interesting statistic is the cumulative probability of default for various sovereign bonds. The site calculates these over a five-year period based on the term structure of interest rates and the price of various credit default swaps.

As of this writing, the five-year probability of default of selected EU countries is as follows:

Looking at these numbers, you may not be alarmed. After all, what is the probability that all four of these countries will default? Multiplying the probabilities together yields 0.4321 × 0.2425 × 0.18 × 0.1718 ≈ 0.0032. That’s not so bad.

The problem is, it’s not correct. Multiplication assumes that each of these default probabilities is independent from the others. But during a financial crisis, all correlations go to one. The correct answer is about 17.18%, the probability that Italy will default. If Italy defaults, that means that the other four have probably already defaulted or are about to do so.

There is another implication of correlations going to one. The EU cannot bail out all of its members. They may be able to bail out Greece and Portugal, but I doubt they will be able to bail out Spain and Italy as well.

The other indicator I’ve been looking at is the risk premium on Greek bonds relative to German bonds. Earlier this month it went from 5.4 percent to 9.6 percent in four days. After the bailout package was announced, it dropped and is today around 5.1 percent (three years ago it was around 0.2 percent). I would not be surprised to see it spike again like it did earlier this month. If, when the crisis came, austerity was politically impossible, what makes anyone think that austerity will be politically feasible when there is no crisis? And why, when the next crisis comes, does anyone think the outcome will be any different?

In case you are wondering, the probability of the US defaulting in the next five years is around 3.51%. This means that the probability we will soon be living in caves is: 3.51%.

Finally, we have more evidence, as if we needed it, that politics isn’t about policy. Politicians say they want to regulate “systemic risk” so that we do not experience another financial crisis. What is the greatest source of systemic risk? You guessed it: government debt.

I’ve been trying to figure out the best investment strategy in light of these facts. Here’s how I’m leaning: invest in leisure—it can never be expropriated. Have a nice day.