Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely

The state of the public finances has worsened substantially in the main advanced economies as a result of the 2008–09 global financial and economic crisis. For some “peripheral” European countries, market participants and some commentators occasionally seem to believe that default (here intended as some form of debt restructuring) will sooner or later inevitably occur. Concerns about fiscal solvency in those countries have been reflected in financial market pressures, large default risk premiums on sovereign bonds, and downgrades by rating agencies. At the time of writing (late August 2010), credit default swap spreads are about 900 basis points in Greece and 300 basis points in Ireland and Portugal. In general, volatility remains high and every auction of government paper—especially in Europe, including in the largest countries—is closely monitored to discern possible triggers of abrupt market reactions.
In our view, the risk of debt restructuring is currently significantly overestimated. Although it is generally wise to assume that market developments reflect economic fundamentals, market overreaction does occur from time to time, with adverse implications for countries’ borrowing costs and debt dynamics. For example, considering data on sovereign bond spreads over the past decades, markets sounded false alarms in the vast majority of episodes.

[…] challenge stems mainly from the advanced economies’ large primary deficits, not from a high average interest rate on debt. Thus, default would not significantly reduce the need for major fiscal adjustment. In contrast, the economies that defaulted in recent decades did so primarily as a result of high debt servicing costs, often in the context of major external shocks. We conclude that default would not be in the interest of the citizens of the countries in question. Fiscal adjustment supported by reforms that enhance economic growth is a more effective response.

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Ecuador debt default

I gave the order not to pay the interest and to go into default,” Mr Correa told reporters in Guayaquil. ”We know very well who we are up against — real monsters.

Ecuador declared default on its 2012 global bonds on Friday over charges the debt was illegally contracted by past governments, leaving investors to deal with its second debt default in less than a decade.

President Rafael Correa’s decision to not pay a $31 million coupon on the government’s 2012 bonds means the country’s two other global bond issues due in 2015 and 2030 are also considered in default, according to cross-default clauses in the contracts.

Possible scenarios after Ecuador debt default

Ecuador defaults on sovereign bonds

Credit default swap of the day: Glitnir

Final Price: Snr 3%, Sub 0,125%. Fellow Icelandic bank Kaupthing’s credit event auction is to be held tomorrow.

Credit Default Swaps: size of the market

From DTCC web site:

Reported estimates of the size of the credit default swap market have so far been based on surveys. These surveys tend to overstate the size of the market due to each party to a trade separately reporting its own side. Thus, when two parties to a single $10 million dollar trade each report their “side” of the trade, the amount reported is $20 million, which overstates the actual size by a factor of two since both reports relate to a single $10 million contract. When examining the outstanding amount of actual contracts registered in the Warehouse (not separately reported “sides”) as of October 9, 2008, credit default swap contracts registered in the Warehouse totaled approximately $34.8 trillion (in US Dollar equivalents). This is down significantly from the approximately $44 trillion that were registered in the Warehouse at the end of April this year.

Interesting is the size of the market Related to Mortgages:

Less than 1% of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities. Mortgage-related index products also have some components relating to residential mortgages and, as a whole, also constitute a relatively small fraction of total credit default swaps registered in the Warehouse.