1930s Style Debt Defaults?

By The Banker | Blog Posts, Wall Street
16 Jan 2014
  • SumoMe

1930s_breadlineA sometime gold-coin buyer and a frequent reader of Bankers Anonymous sent me a message a few days ago, linking to the CNBC headline “1930s-style debt defaults likely, says IMF,” and with the simple question: “Mike – True?”

Harvard economists Carmen M. Reinhart and Kenneth S. Rogoff’s latest paper, commissioned by the IMF and published in December 2013, re-raises the specter of sovereign default in the so-called ‘developed world,’ warning of restructuring, restrictive capital controls, and debt write-offs.

Their paper was rewarded and echoed with headlines from Business Insider like “Extreme Debt Means 1930s-Style Defaults May Be Coming to Much of the Western World” and CNBC’s “1930s-style debt defaults likely, says IMF,” the headline that prompted my reader’s email to me.

This seemed like a great opportunity to reflect on the problem of different, confusing, contradictory messages constantly streaming from the Financial Infotainment Industrial Complex.

Academia, Click-bait, and Markets

Those headlines, loosely based on the Reinhart and Rogoff IMF paper, are a great example of the giant gulf between financial academia, click-bait, and actual markets. Each information source follows its own rules and logic – but mixed up together provide a cacophony of worse-than-useless dis-information.

First, academia on its own terms

Professors of international economics should consider a wide variety of scenarios, and they should present historical data, as Reinhart and Rogoff have done, with their book This Time is Different: Eight Centuries of Financial Folly.

[I confess I have not yet read this, but I suspect I will find this a useful addition to other books I have enjoyed on sovereign debt defaults, such as A Century of Debt Crises in Latin America: From Independence to The Great Depression 1820-1930 by Carlos Marichal.]

I enjoyed the Reinhart and Rogoff paper, with its useful historical data, reminding readers that sovereign debt defaults in Europe are not particularly rare.  In addition, sovereign defaults sometimes come hidden in sheep’s clothing – as when a combination of capital controls, high inflation, or forced ‘savings’ from captive sources such as workers’ pensions effectively bail out overly indebted governments.

As a former emerging markets bond guy I read Reinhart and Rogoff’s work with much interest.  Here’s a summary of their main points, and my reactions:

  1. Drastic sovereign debt restructurings are historically more common than many realize, and come in a variety of forms.  [Totally agree]
  2. Financial repression, while brutal and inefficient, probably reduces financial excess, and therefore financial crises.   [Totally agree]
  3. The 5 year-old crisis we are in will involve more explicit restructuring of sovereign debt in the so-called ‘developed’ world, presumably peripheral Europe.  [Mmm. Squinting. That depends.  Doubtful.]
  4. We will see a return of ‘financial repression’ in the ‘developed world.’ [I see no evidence of this.  Or, I guess it depends how you define ‘financial repression.’]

Breadline_1930s_art

But what about the click-bait?

Reinhart and Rogoff are legitimate economists (at a reasonably decent University) so it’s not surprising that they have produced serious work on historical sovereign debt restructurings.  I wonder, however, to what extent they anticipated (and even encouraged?) the click-bait aspect of their paper.

“1930s-style debt defaults likely, IMF says” is a totally misleading version of their report.

“Ex-Goldman bond salesman may make billions blogging his random opinions, says blogger,” is a headline I could write about myself, but it would have as much relationship to the probabilistic truth as that CNBC headline has to the IMF report.

Unfortunately, CNBC – and the rest of the Financial Infotainment Industrial Complex – runs on nonsense click-bait, so people like my reader who sent me the email query get pummeled with emotionally-charged or scary bullshit, on an hourly basis.

Market Data

How do I know that – on a probabilistic basis – both the click-bait headline as well as points 3 & 4 of the Reinhart-Rogoff paper can be safely ignored?

Because what neither academia, nor the click-bait-setting members of the Financial Infotainment Industrial Complex typically take into account is that we have a ton of aggregated financial information available in markets about exactly their topic.  Right now.  At all moments.

The bond market

At any given moment – with updates on a minute-by-minute basis – the most–informed people in the world on sovereign risk – with the most to gain or lose financially – are indicating the probability of default on all sovereign debts.

Bond traders – at mutual funds, hedge funds, banks, insurance companies, and broker-dealers – control the flow of capital into or out of investments in sovereign debt.

Yield or bond spread indicate aggregate market perceptions of risk by the most knowledgeable and interested people in the world.

The constant buying and selling of bond traders sets a price, in yield terms, that tells us a lot about what the odds of default are.  The higher the yield, the higher the controller of capital is demanding to take the risk of the bond.  In aggregate, the self-interested decisions of bond traders give a very full view of the total risk associated with these bonds.

The most common way bond traders compare the relative risk of sovereign debt is through a ‘spread,’ which means the additional yield investors receive over the yield of a riskless bond yield.[1]  A 1% bond yield spread, or as bond traders would actually say, “100 basis points”[2] spread over an equivalent riskless bond, indicates that highly informed and highly interested investors find the bond mildly, but not extraordinarily, riskier than a ‘riskless’ bond

Most of us do not see the minute-by-minute information on government bond spreads but we can access it, updated at least daily, on the global government bond yield pages of financial news sources like The Financial Times or Bloomberg or The Wall Street Journal.

Why so much about the bond markets?

Why am I going into this excruciating detail about the bond markets?  Because if you know something about how the bond markets work, and what information they convey, you can interpret both the Reinhart-Rogoff thesis on defaults and the Financial Infotainment Industrial Complex’s click-bait headlines for what they are.

In sum:

Reinhart-Rogoff: Improbable

CNBC’s headline: Nonsense

How do I know this?  Because the bonds markets give us bond spreads on the sovereigns they reference.  Here are some select 10-year bond spreads this week from The Wall Street Journal’s global government bond page:

Italy:  97 basis points (less than 1% yield premium)

Portugal: 225 basis points (2.25% yield premium)

Spain: 88 basis points (less than 1% yield premium)

The bond market is saying, with these spreads, that it finds these European bonds mildly risky, but not terribly risky.  Default, while possible, is highly improbable over the next ten years.

Of course, Greece already restructured its sovereign debt, so Reinhart-Rogoff’s ‘prediction’ came true.  But since they published their ‘prediction’ in December 2013, however, they really can’t take credit for being nearly 2 years late.

So, no, 1930s-style defaults are neither likely to happen nor likely to be widespread, as implied by the IMF paper, and by CNBC’s headlines.  Of course, anything can and will happen with markets, but the smart money’s not betting on that, and you shouldn’t either.  Leave the fear-mongering to Harvard economists and click-bait headline writers.

Please see related post:  The biggest, mostly ignored, point of Reinhart Rogoff’s IMF paper.

and upcoming related post on Reinhart Rogoff: The irony of political affiliations.

 


[1] Among bond traders primarily trading in US $ Currency, a ‘riskless bond’ for the purpose of determining bond spread, is usually a similar maturity US Treasury.  Bond traders in Europe or Japan might use a different riskless bond as the basis for comparing risk in their own currency.  We can argue about whether US bonds, or Japanese bonds, or German bonds are actually ‘riskless,’ and traders do, but traders also need a convention for comparison, so US Treasuries often serve that purpose regardless of whether its truly ‘riskless’ in the absolute sense.

[2] A basis point is 1% of 1%.  Hence, 100 basis points for every 1% in yield or yield spread.  If we say 5 basis points, or 5bps, (pronounced “5 bips”) that means 0.05% in yield, or spread terms.

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5 Comments

  1. JB McMunn says:

    You can’t be serious. Are these the new & improved bond traders – the ones who replaced the stupid bond traders from 2007? The ones with all the information at their fingertips?

    Would you really lend money to Spain for 10 years at 3.8%? Of course you would, because Draghi promised to do “whatever it takes” – even though the ECB’s options are in fact severely limited. They were lucky to contain Cyprus. Remember when France was on the asset side of the EZ analysis? Now it’s probably their worst liability. It makes one yearn for the simple days when people were merely afraid of what could happen in Italy. Good times.

    Reality check:

    New issues of syndicated leveraged loans exceeded half a trillion in 2013 ($600 billion in 2007)

    Almost 60% of loans sold in 2013 were cov-lite (25% in 2007).

    Junk bonds hit a new record in 2013. CCC sales exceeded $15 billion.

    These brilliant people with all the info in the world are buying GARBAGE or, more likely, selling it along to greater fools.

    NYSE margin balances are close to 2007 and rising, both in nominal terms and as % of market cap. Net investor credit is worse than 2000 or 2007.

    Tell your pen pal to keep stacking.

  2. JB McMunn says:

    Forgot to mention what the aggregate judgment of the bond market is: 10 year Treasury yield currently about 2.8% vs 1.8% a year ago.

    • The Banker says:

      I hear you…sometimes it doesn’t make much sense where current market levels stand…And sometimes, there’s collective madness, and bubbles, and the market is just plain wrong. On the other hand, I would argue that’s rarer than you think.
      When the market is totally wrong (2007 sub-prime mortgage CDOs would be the last time we can point to large-scale madness with perfect 20/20 hindsight certainty) there are extraordinary profits to be made by going against the grain, and being right. That’s the John Paulson trade, and the tiny handful of folks featured in Michael Lewis’ The Big Short.
      For current bond levels to be totally wrong, that implies that there will be tons of money for smart guys like us to take advantage of the current idiocy, shorting Spanish 10 year bonds. I don’t know. I don’t think collective madness happens that often.
      My baseline assumption remains that markets are efficient, and if we consistently know better than markets, than we can be billionaires. Not being one myself (YET!) I acknowledge my ignorance in the face of markets, most of the time.

  3. JB McMunn says:

    The problem is twofold.

    1. Central bank interference has destroyed conventional price discovery.

    2. Shadow banking. You can’t possibly have sufficient info on that to have an efficient market.

    In addition the vast majority of investors, both professional and retail, have only known a post-Bretton Woods world. They have only seen the credit expansion part of the cycle. What worked for the past 40 years might not work bouncing off the zero bound.

    A lot of the whiz kids on Wall Street were born after the 1987 crash, started middle school when LTCM went down, and had their bar mitzvah when the dot-com bubble burst. There are hedge fund guys out there who were still in college in 2008.

    If you read some of the Depression-era work (such as Garet Garrett) you get a very bad feeling of deja vu.

    • The Banker says:

      I haven’t read Garrett (but I’ll look it up!) and I agree we collectively forget the lessons of the past – every generation has to relearn this stuff the hard way.
      Having said that, don’t you think anyone in any position to control substantial capital right now has 2008 front and center in their mind? If anything I would imagine people are gun-shy from the near collapse of everything. I can’t prove this of course, so I’m just guessing.
      On the issue of Central Bank dominance of everything…I agree we’re in uncharted territory as far as the removal of the central bank crutch. When/if that happens, we can’t be certain if asset prices maintain current levels or just collapse. My best guess is they don’t collapse, but of course I don’t know.

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