Account for what follows when a country defaults.

FRM® Part II · Credit Risk Measurement and Management · Country Risk: Determinants, Measures, and Implications · FRM2.CR.8.d

The idea

A sovereign cannot be liquidated, so default is followed by a negotiated restructuring in which creditors accept an exchange, longer maturities or lower coupons, a loss often called a haircut. The country usually loses access to international capital markets for a period and pays higher spreads when it returns. The currency typically falls and capital leaves, which raises the local cost of foreign currency debts for firms and banks. Banks holding government bonds suffer capital losses and cut lending, and corporate ratings are pulled down because firms are rarely rated above their sovereign. Real output usually contracts, and political change often follows. Here PD is the probability of default and LGD, the loss given default, is one minus the recovery rate. The expected loss on a sovereign exposure is then given by the following relation. EL = PD × LGD × exposure. The common mistake is to forget the recovery rate or to use it in place of the loss rate.

Formulas

Expected loss on a sovereign exposure

expected loss = PD × (1 − recovery rate) × exposure

PD: the probability of default
recovery rate: the share recovered after restructuring
exposure: the amount held

Multiply by the loss rate, not by the recovery rate.

Haircut in a sovereign debt exchange

haircut = 1 − PV(new) ÷ PV(old)

PV(new): the present value of the new bond's cash flows
PV(old): the present value of the old bond's cash flows

Discount both at the same exit yield and measure against the old bond's present value, not its face value.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which is a typical consequence of a sovereign default?

The sovereign's debt is liquidated by a bankruptcy court and the proceeds go to creditors. Sovereigns have no bankruptcy regime, so there is no liquidation to distribute.Why not: No court can liquidate a sovereign; creditors must negotiate a restructuring.
The country's borrowing costs fall because its debt burden has been reduced.Why not: The lower burden is outweighed by lost credibility; spreads rise after default.
The government's rating rises because debt relief improves its balance sheet.Why not: Default leads to downgrades, often to default grades, not upgrades.
The country loses access to international capital markets for a period and pays higher borrowing costs when it returns. - correct

Default damages credibility. Market access is lost or restricted and borrowing costs rise, even though the debt burden itself falls after restructuring.

A harder one

A domestic bank holds a large portfolio of its own government's bonds. The government defaults and restructures the bonds with a significant haircut. What is the most direct follow-on effect?

The bank's profits rise, because the restructured bonds can now be bought at lower prices. The loss on bonds it already owns is booked first and outweighs any later opportunity.Why not: Ignores the loss on the existing holding, which hits capital immediately.
There is no effect, because government bonds carry a zero regulatory risk weight.Why not: A zero weight is a regulatory convention; the economic loss on the holding is real.
The bank's capital is impaired, so it cuts lending to firms and the contraction deepens the recession. - correct
Deposits rise as savers flee to safety, so the bank can lend more.Why not: A default shock erodes confidence in the banking system; deposit flight, not inflow, is the typical risk.

Sovereign losses transmit to banks that hold the debt. Lower capital means less credit, which spreads the default shock to the private sector.

The hardest tier

An investor holds USD 40 million of a sovereign's foreign currency bonds. The one-year probability of default is 3.5 percent and, after restructuring, bondholders are expected to recover 45 percent of the exposure. The expected loss is closest to:

USD 1.40 millionWhy not: Ignores recovery, taking probability of default times the full exposure.
USD 0.63 millionWhy not: Multiplies probability of default by the recovery rate (45 percent) instead of by the loss rate (55 percent).
USD 0.77 million - correct
USD 7.70 millionWhy not: Misplaces the probability, using 35 percent in place of 3.5 percent.

Expected loss = PD x (1 - recovery) x exposure = 0.035 x 0.55 x 40 = USD 0.77 million.

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