Monday, July 19, 2010

Do financial markets think Spain will default?


But that won't stop the government and european authorities from inflicting pain on their populations in the name of fiscal austerity.

As I'm sure Maladjusted's readers already know, Spain is the latest object of European sovereign debt fears. Following Greece's lead, Spain's borrowing costs have increased over the last two months on concerns that the government won't be able to service it's debt and will face a rollover crisis. As a consequence the government is moving ahead with large austerity plans--cutting spending and raising taxes while unemployment remains above 20 percent.

Advocates of austerity claim that if the government doesn't make tough choices to bring down its deficit and reassure creditors interest rates will spike emerging market-style, causing the debt to explode. Spain, the argument goes, will find itself forced to default on its debt, potentially bringing down the whole Eurozone with it.

Austerity advocates, in other words, argue that markets think Spain is in danger of defaulting, and if we don't heed their warning we'll have serious trouble. But first of all, that's a stupid anthropomorphism (markets don't have agency or thoughts, last time I checked). But more to the point, assuming markets are capable of "thinking" anything, do they actually think Spain is in danger of defaulting?

Well, one way of answering that question is to use the price of credit default swaps (CDS) on Spain's public debt--that is, how much it costs to insure oneself against the possibility of a default.

[Spain: Implicit probably of default, April-July, 2010]

The graph above, courtesy of Maladjusted Graphs™, shows the "implicit" probability of default on Spain's government bonds. The idea is simple: the price of ensuring oneself against a default should reflect the chance of default and how much of their money investors expect to get back in the event of a default (i.e. how big of a "haircut" bondholders expect). In other words, the price of a CDS should equal the chance of default times the haircut rate. The price to insure oneself against default is higher the higher the expected chance of default and the larger the haircut.

So, the orange line above shows the implicit probability of default under a relatively optimistic assumption about the size of expected haircuts. In this case, I'm assuming markets only expect to lose $10 on every $100 worth of bonds. As can be seen above, under this assumption at the beginning of April markets only thought there was an 11% chance of default. But then as all the sovereign debt hysteria surrounding Greece started making headlines markets started to "think" the chance of default was much higher, reaching 28% on May 6.

But here's the thing. This is only the case if markets expect the default to be a very small one. Getting back 90% of your money when a government defaults is relatively rare in the history of sovereign debt crises.

So, what if we assume Spain is like Argentina or Russia and if the government defaults investors would only get back $30 for every $100? Well, the yellow line above shows just this scenario, and as can be seen the chance of default is really, really low. In fact, the crisis hysteria back in May shows up as nothing but a tiny blip, peaking at a terrifying 3.9%!

So what's the moral of the story?

The fact of the matter is that if markets really do think a default is likely, it's not reflected in market prices, which are, after all, the only coherent measure of what markets "think." That, or they don't expect to take a very big hit in the unlikely event the government decides to default.

In other words, markets either think Spain is like Argentina but the actual chance of default is really low or they think the chance of default is high but don't expect to actually lose any significant amount of money.

Then do the markets think Spain will default? Sorta! Should the government heed their warning? No! But that doesn't mean it can't seriously structurally maladjust itself to fight imaginary threats in the meantime.

1 comment: