Toward a Bottom-Up Approach to Assessing Sovereign Default Risk


Ed Altman, Max L Heine Professor of Finance, NYU Stern School

Ahead of SuperInvestor 2011 in Paris we showcase new research by Ed Altman, Max L Heine Professor of Finance, NYU Stern School. He will be addressing the conference on the current conditions and outlooks in sovereign and corporate credit markets – and how far Europe and the Euro are on the brink.

During the past three years, bank executives, government officials, and many others have been sharply criticized for failing to anticipate the global financial crisis. The speed and depth of the market declines shocked the public. And no one seemed more surprised than the credit rating agencies that assess the default risk of sovereign governments as well as corporate issuers
operating within their borders.

Although the developed world had suffered numerous recessions in the past 150 years, this most recent international crisis raised grave doubts about the ability of major banks and even sovereign governments to honor their obligations. Several large financial institutions in the U.S. and Europe required massive state assistance to remain solvent, and venerable banks like Lehman Brothers even went bankrupt. The cost to the U.S. and other sovereign governments of rescuing financial institutions believed to pose “systemic” risk was so great as to result in a dramatic increase in their own borrowings.

The general public in the U.S. and Europe found these events particularly troubling because they had assumed that elected officials and regulators were well-informed about financial risks and capable of limiting serious threats to their investments, savings, and pensions. High-ranking officials, central bankers, financial regulators, ratings agencies, and senior bank executives all seemed to fail to sense the looming financial danger.

This failure seemed even more puzzling because it occurred years after the widespread adoption of advanced risk management tools. Banks and portfolio managers had long been using quantitative risk management tools such as Value at Risk (“VaR”). And they should also have benefited from the additional information about credit risk made publicly available by the new market for credit default swaps (“CDS”).

But, as financial market observers have pointed out, VaR calculations are no more reliable than the assumptions underlying them. Although such assumptions tend to be informed by statistical histories, critical variables such as price volatilities and correlations are far from constant and thus difficult to capture in a model. The market prices of options—or of CDS contracts, which have options “embedded” within them—can provide useful market estimates of volatility and risk. And economists have found that CDS prices on certain kinds of debt securities increase substantially before financial crises become full-blown. But because there is so little time between the sharp increase in CDS prices and the subsequent crisis, policy makers and financial managers typically have little opportunity to change course.

Most popular tools for assessing sovereign risk are effectively forms of “top-down” analysis. For example, in evaluating particular sovereigns, most academic and professional analysts use macroeconomic indicators such as GDP growth, national debt-to-GDP ratios, and trade and budget deficits as gauges of a country’s economic strength and well-being. But, as the recent Euro debt crisis has made clear, such “macro” approaches, while useful in some settings and circumstances, have clear limitations.

In this paper, we present a totally new method for assessing sovereign risk, a type of “bottom-up” approach that focuses on the financial condition and profitability of an economy’s private sector. The assumption underlying this approach is that the fundamental source of national wealth, and of the financial health of sovereigns, is the economic output and productivity of their companies. To the extent we are correct, such an approach could provide financial professionals and policy makers with a more effective means of anticipating financial trouble, thereby enabling them to understand the sources of problems before they become unmanageable.

Read the full text here.


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