Default Episode Research Articles

Sovereign debt default and inequality

AbstractBased on a sample of 124 developing countries over the period 1980–2016, we find that default increases inequality. This result, which passes a series of robustness tests, is sensitive to the size of the debt in default, the duration of the default episode, the institutional quality, the level of development, and the type of default (on external or domestic debt) and may persist until 5 years after the end of the default episode. Besides, the declines in redistributive capacity characterized by lower taxes and subsidies and social spending are identified as channels through which default increases inequality in default countries vis-à-vis nondefault countries. Finally, additional results show that default also raises wealth inequality.

Is to Forgive to Forget? Sovereign Risk in the Aftermath of a Default

We examine the link between sovereign defaults and credit risk, by taking into account the depth of a debt restructuring and by distinguishing between commercial and official debt. The focus is on debt restructuring events, which take place at the end of a default spell. We use a novel methodology (Jorda and Taylor 2016) to estimate the average treatment effect of a default episode on our outcome variables, agency ratings and bond yield spreads, accounting for the endogeneity of the default. Our results show that the average treatment effect on ratings is negative (and positive for bond spreads) up to seven years following a default, while the opposite holds for a default with official creditors. Our results are robust to using a panel analysis, which allows us to investigate on the importance of the (final) haircut size. Specifically, we and that the rating (spread) variation (increase) is larger for cases with deeper haircuts. Therefore, we and evidence that official and private defaults may have different costs and then induce selective defaults.

On the role of financial aid in a default episode

Our aim is to explore the role of financial aid in a default episode. To that end, we develop a dynamic stochastic quantitative model of sovereign default featuring fiscal policy, endogenous financial aid and risk-averse foreign lenders. After calibrating the model, we feed output shocks into the model to show that it captures some of the most salient features of the fiscal and debt situation in Argentina during the 1998–2002. This underscores the economic nature of the decision to default and the role that official aid could have taken in avoiding such an event. In effect, given the economic challenges endured by Argentina, a full-fledged default took place. In addition, we discuss a number of policy implications associated with financial aid programs aimed at preventing sovereign default episodes.

Risk sharing contracts with private information and one-sided commitment

In a repeated unobserved endowment economy in which agents negotiate long-term contracts with a financial intermediary, we study the risk sharing implications of the interaction between incentive compatibility constraints (due to private information) and participation constraints (due to one-sided commitment). In particular, we assume that after a default episode, agents consume their endowment and remain in autarky forever. We find that once they are away from autarky today, if the probability of drawing the highest possible endowment shock is sufficiently small, the optimal contract prevents agents from reaching autarky tomorrow and, thus, from being “impoverished.” Moreover, an invariant cross-sectional distribution of lifetime utilities (or values) exists. A numerical example shows that the mass of agents living in autarky can be zero in the limit.

Sovereign default and maturity choice

This study develops a novel model of endogenous sovereign debt maturity that rationalizes various stylized facts about debt maturity and the yield spread curve: first, sovereign debt duration and maturity generally exceed one year, and co-move positively with the business cycle. Second, sovereign yield spread curves are usually non-linear and upward-sloped, and may become non-monotonic and inverted during a period of high credit market stress, such as a default episode. Finally, output volatility, impatience, risk aversion, and especially sudden stops, are key determinants of maturity, both in our model and in the data.

The Cost of Defaults: The Impact of Haircuts on Economic Growth

This paper studies the impact of debt default on economic growth taking into account the depth of a debt restructuring. More specifi cally, creditors’ losses (or haircuts) are used as proxies of the severity of the default episoded. Analyzing 89 defaults in 72 countries over the period 1979-2005, consistently with previous results in this literature, we fi nd that defaults have a negative and signifi cant impact on short-term output growth. Moreover, controlling for the severity of the default through the haircut’s size, we fi nd that the severity of the default is indeed correlated with a further contraction in output one year after the default and with a positive increase in output three years after the default. Therefore, the use of a variable which is taken as a proxy of the severity of the default episode allows us to detect a more lasting (and eventually positive) effect of debt default on growth.

The Elusive Costs of Sovereign Defaults

Few would dispute that sovereign defaults entail significant economic costs, including, most notably, important output losses. However, most of the evidence supporting this conventional wisdom, based on annual observations, suffers from serious measurement and identification problems. To address these drawbacks, we examine the impact of default on growth by looking at quarterly data for emerging economies. We find that, contrary to what is typically assumed, output contractions precede defaults. Moreover, we find that the trough of the contraction coincides with the quarter of default, and that output starts to grow thereafter, indicating that default episode, rather than a further decline, seems to mark the beginning of the economic recovery. This suggests that whatever negative effects a default may have on output, they are driven by its anticipation, independently of whether or not the country ultimately decides to validate it.

On Graduation from Default, Inflation, and Banking Crises: Elusive or Illusion?

This paper uses a data set of over two hundred years of sovereign debt, banking and inflation crises to explore the question of how long it takes a country to "graduate" from the typical pattern of serial crisis that most emerging markets experience. We find that for default and inflation crises, twenty years is a significant market, but the distribution of recidivism has extremely fat tails. In the case of banking crises, it is unclear whether countries ever graduate. We also examine the more recent phenomenon of IMF programs, which sometimes result in "near misses" but sometimes end in default even after a program is instituted. The paper raises the important theoretical question of why countries experience serial default, and how they might graduate.

Equilibrium Sovereign Default with Endogenous Exchange Rate Depreciation

Sovereign default is often associated with disturbances in a country’s trade relations. Often the defaulter’s currency depreciates while trade volume falls drastically. This paper develops a model to incorporate real depreciation along with sovereign bankruptcy. The exchange rate is determined in equilibrium as the relative price of imports. We demonstrate that a default episode can imply up to a 30% real depreciation. This matches the depreciations observed in crisis events for developing countries. We argue that much of the exchange rate movement is explained by market clearing adjustments to trade disruptions in the aftermath of default.

HETEROGENEOUS BORROWERS IN QUANTITATIVE MODELS OF SOVEREIGN DEFAULT*

We extend the model used in recent quantitative studies of sovereign default, allowing policymakers of different types to stochastically alternate in power. We show that a default episode may be triggered by a change in the type of policymaker in office, and that such a default is likely to occur only if there is enough political stability and if policymakers encounter poor economic conditions. Under high political stability, political turnover enables the model to generate a weaker correlation between economic conditions and default decisions, a higher and more volatile spread, and lower borrowing levels after a default episode.

Default and Settlement: Payment Resumption and Disclosure of Information

A country with a history of default has the advantage of having revealed information to the credit market on how it has conducted itself while confronting a default episode and how it might manage a possible default situation in the future. Under the assumption that a borrower is excluded for a finite period of time from the credit markets once it has defaulted, and that the period of exclusion can be used to negotiate the settlement conditions, this paper shows, using survival analysis techniques, that disclosure of information by the debtor will lead to a reduction in the time of the negotiation; that is, an increase in the settlement rate. This disclosure of information can be in the form of previous default or the credible announcement of fiscal reforms. Engaging in debt reduction or rescheduling under concessionary rates hurts the debtor's probability of reaching an agreement and settling the debt. The paper shows, using Standard and Poors dataset which includes default episodes that date back to the 1820s, that a country with a history of default has a higher probability of leaving the period of exclusion sooner than a country that has defaulted for the first time. Uncertainty reduction increases the settlement rate.

The credit spread dynamics of Latin American euro issues in international bond markets

This paper investigates two important relationships using the sovereign issues made by major Latin American economies in the international bond market: the determinants of credit spread changes using variables derived from structural and macroeconomic theory and the impact of a default episode on the underlying equilibrium dynamics. We find four significant determinants of credit spread changes: an asset and interest rate factor—consistent with structural models of credit spread pricing; the exchange rate—consistent with macroeconomic determinants and the slope of the yield curve—consistent with a business cycle effect. Also, an intra-regional analysis of sovereign yields reveals a shift in the long-run equilibrium dynamics around the Argentine default on the 23 December 2001.

The Dynamics of Credit Spreads on Latin American Eurobonds

We investigate two important relationships using the most liquid and option-free, sovereign Eurobond issues of major Latin American economies: the determinants of credit spread changes using variables derived from structural and macroeconomic theory; and the impact of a default episode on the underlying equilibrium dynamics of credit spreads. We find four significant determinants that drive the credit spreads in these markets: an asset and interest rate factor - consistent with structural models of credit spread pricing; exchange rate factors - consistent with macroeconomic determinants and the slope of the yield curve - consistent with a business cycle effect. The statistical significance of the exchange rate factor, which also proxies for country risk and the slope variable may be attributed to the sovereign risk premium demanded by investors before buying these bonds. We also find significant autoregressive moving average (ARMA) effects when modelling spread returns indicating a degree of inertia associated with the pricing of sovereign credit spreads in these emerging markets. Finally, an intra-regional analysis of sovereign yields reveals a shift in the long run equilibrium dynamics around the Argentine default on the 23rd of December 2001. Specifically there was a decline in the importance of the cross border cointegration relationship: intramarket relationships have become more important than intermarket (bivariate or pairwise) relationships.

Heterogeneous Borrowers in Quantitative Models of Sovereign Default

We extend the model used in recent quantitative studies of sovereign default, allowing policymakers of different types to alternate in power. We show that a default episode may be triggered by a change in the type of policymaker in office, and that such a default is likely to occur only if there is enough political stability and if policymakers encounter poor economic conditions. Under high political stability, political turnover enables the model to generate a weaker correlation between economic conditions and default decisions, a higher and more volatile spread, and lower borrowing levels after a default episode.

The Elusive Costs of Sovereign Defaults

Few would dispute that sovereign defaults entail significant economic costs, including, most notably, important output losses. However, most of the evidence supporting this conventional wisdom, based on annual observations, suffers from serious measurement and identification problems. To address these drawbacks, we examine the impact of default on growth by looking at quarterly data for emerging economies. We find that, contrary to what is typically assumed, output contractions precede defaults. Moreover, we find that the trough of the contraction coincides with the quarter of default, and that output starts to grow thereafter, indicating that default episode seems to mark the beginning of the economic recovery rather than a further decline. This suggests that, whatever negative effects a default may have on output, those effects result from anticipation of a default rather than the default itself.

The Hazard Rates of First and Second Defaults

This article examines hazards of repeated mortgage default, conditional on reinstating out of an initial default episode. Results indicate that subsequent default risk for reinstated borrowers is significantly greater than the risk of first default, especially during the first two years after a default episode. In addition, economic factors helpful in predicting first defaults are not helpful in predicting subsequent default episodes. This has important implications for mortgage investors and servicers as industry foreclosure avoidance efforts intensify.

Modeling the Conditional Probability of Foreclosure in the Context of Single‐Family Mortgage Default Resolutions

Both empirical and pricing‐simulation models of mortgage default focus on foreclosure in a one‐step decision framework. Such models are misspecified to the extent that mortgage default and foreclosure are two separate decisions or events, where foreclosure is but one outcome of a default episode. This study examines the dynamics of mortgage borrower default episodes using a large sample of FHA‐insured single‐family mortgages. We estimate the influence of borrower characteristics, mortgage terms, and economic conditions on probabilities of various resolutions, highlighting under what conditions foreclosure is more likely to result from mortgage default.

Default, market microstructure, and changing trade patterns in forward markets: A case study of North-Sea oil

Default (or credit) risk is a central difference between forward and futures markets. Empirical tests have found little difference between forwards and futures prices, but these tests have been conducted on markets where such risk is minimal (e.g., foreign exchange), so that even if default risk is in general an important difference between forward and futures trading, they would have been unable to detect its effects. In contrast, this paper presents a case study of a market, for forward delivery of a type of crude oil from the North Sea, that experienced widespread and well-documented defaults when the spot price of the underlying commodity plunged from roughly $30 to roughly $10 per barrel in a short period of time in early 1986. The defaults were by relatively small, lightly-capitalized trading companies, firms that neither produce nor consume the physical commodity. Because information on defaults in financial markets is scarce, the paper describes the circumstances surrounding the default episode in some detail. The market survived the default episode with market microstructure unaltered, and still flourishes, despite the successful introduction of a futures market in the same commodity by the (London) International Petroleum Exchange. Patterns of trade changed, however. The paper examines the hypothesis that investment banks, which entered the market following the default period, provided intermediation services to market participants, thereby substituting to an extent for a clearinghouse. Taking advantage of the information on the buyer and seller in each transaction, the paper presents nonparametric tests for changing patterns of forward trade.