Implied Default Rates

Today’s bond auction has attracted a lot of media attention. However, quite a lot of the comment has been a bit confused. Let me set out the usual framework that economists use to think about bond yields. Our more financially sophisticated readers know this stuff anyway but it’s still worth briefly spelling out.

Consider an investor who has two options for their investment.

Option A is to purchase a risk-free bond which carries an interest rate of RF.

Option B is to purchase a bond with potential default risk. This bond delivers two possible outcomes. The first outcome occurs with probability p and in this case, the bond is defaulted on and the investor only recovers a percentage c of their original investment. The second outcome B occurs with probability 1-p and in this case the bond delivers the promised interest rate of RR and also repays the principal.

(Weighted) averaging over these two outcomes, the expected return from option B is

p(c-1) + (1-p) RR

Now assume that investors are risk-neutral, meaning they will pick the bond with the highest average return (and won’t shy away from option B just because it carries some uncertainty).

In this case, for investors to be willing to purchase both bonds, they must have the same average expected return. Setting the above return for option B equal to RF and re-arranging, this determines the interest rate on the risky bond as

RR = RF / (1-p) + p (1-c)

If one knows what the “recovery rate” parameter c is, then one can also back out the implied probability of default as

p = (RR – RF ) / (1 –c + RR)

Now to our current situation. As of this evening, the FT is reporting yields on ten-year Irish bond at annualised rates were 6.3% while the comparable German bond was yielding 2.46%. Let’s use 0.5 as the implied recovery rate should Ireland default. Now plug in RR = .063, RF = .0246, C = 0.5

p = (0.0630 – 0.0246) / .563 = .0682

When considering ten-year bond yields, this tells us the implied probability that the bond will not default over the 10 years is (1-.0682)^10 = 0.493.

In other words, this simplified calculation would suggest that investors are pricing in that a default is more likely than not at some point in the next ten years.

So, when one hears a Fianna Fail TD say on Prime Time say that if international investors didn’t have confidence in Ireland, they wouldn’t be willing to invest in the country (i.e. purchase sovereign bonds) it needs to be kept in mind that the rates on longer-dated sovereign bonds suggest that these investors believe that it’s as likely as not that the country will default over the next ten years. Not much of a vote of confidence.

Now, of course, the framework above is very basic. One can assume that investors are not risk-neutral which would mean there would be a risk premium in addition to the one related to default probability. This would lower the estimated default probability but it wouldn’t change the damage that perception of the possibility of default is doing.

Also, the 50% figure for recovery rate might be kind of low. A recovery rate of two-thirds would give a higher implied default probability of also about two-thirds from the above framework.

The other line I heard going round today was how we shouldn’t be surprised that the auction was successful because the rates being offered were “very attractive.” This is wrong on two counts. First, the rates were determined in an auction—the NTMA didn’t set a high minimum rate that they were willing to pay to attract interest. Second, once we know the market is factoring in default risk, there’s no point in judging bond yields as being “attractive” just because they are high. The high rates are compensation for the possibility that you might lose a lot of money if things go badly.

A key point to keep in mind is one that has been stressed recently by Willem Buiter. When perceived default probabilities rise there can be two possible self-confirming equilibria. In the good one, the government calms the nerves of the markets, borrowing rates decline and the day is saved. In the bad one, the high yields due to high default probabilities start to make fiscal stabilisation seem more difficult, which further raises estimated default probabilities until borrowing from the bond market becomes unfeasibly expensive or else simply impossible.

80 replies on “Implied Default Rates”

@KW

Ta for tutorial.

The 6%+ looked ‘attractive to me [posing as a virtual external]’ – especially when one factors in the political from EC that no EZ sovereign will (be allowed to) default) ……. and viewing the PlanB pot of 700b+ that EU has pulled together ……. & the Governor’s comments yesterday ……. some of Eoin’s tutorials on earlier thread ….. and the fact that this 1.5b at this high rate is but a small part of the overall Irish sovereign pot …….. and the conventional …er … wisdom (if such a term still exists with any credibility in macroeconomics) that 6% is only a bother if it is sustained for a ‘while’ …

This is excellent. Thank you. Your lecture notes were fantastic too.
Economics is psychology on a grand scale. Dealing with the organism of a market – motivated by a search for profit but I don’t think that human behaviour always conforms strictly to a proper evaluation of probability (the momentum of sentiment always has to be factored in).
There is an underlying logic to this.
Unfortunately logic is very much lacking from Brian Lenihan’s approach. It is odd the relish with which he pursues infliction of pain. Michael O Sullivan used the word masochism to describe our response to the crisis tonight on Primetime. Perhaps ministerial sadism is more apt. Can you factor in personal dysfunction into your model? Economics is as strange as people!

Can I just ask a simple question (in addition to this one) in relation to the Bond Markets.

Todays sale of government bonds was said to be significantly overly subscribed yet the interest rate was very high.
Surely in any market where you have an excess of buyers you can increase the cost so that you get the best price, which goes to the highest bidder.
Surely if the bonds where oversubscribed, this indicates that they were offered with too high a yield. What am I missing about the way these ‘auctions’ operate?

@Sam
agree it all looks a bit contrived. Is there a ceiling at which the ECB start to buy and the others then follow? I dunno

How much can be attributed to investors pushing up the rates on the basis of believing that the EU will not allow a member state to default and trying to achieve maximum returns. If there was a real perceived risk of default then surely the rates would be at least in the teens?

@Sam.
I asked the same question in another forum and the explanation that I received was that the auction was oversubscribed because the yield offered was so high (generous) that investors simply could not refuse such an offer.

To my simple mind, I would have assumed that if there was pentup demand for a Irish debt that NTMA would be able to negotiate a more fabourable (less expensive) yield.
But seemingly, demand and supply doesn’t work that way in this instance.

@KW

Went back to see that bit on primetime – and from the internal serf perspective which is where ‘I am where I am’ ………….. Ms Burton and Mr O’Sullivan sounded as if they were commenting on this blog 12-18 months ago ……… with those here who place the interests of Irish Citizenry first …

You noted three weaknesses in Gov on a recent thread …….. the fourth is TIME – this gov has no conception of its importance ………

On V Browne earlier, which I did tune into, GP now setting scence for cuts in social welfare, pensions, Blind Biddy’s bus pass, or whatever their FF masters come up with …….. no wonder Twitter was hacked earlier …

> What am I missing about the way these ‘auctions’ operate?

I think the rate offered is progressively raised until a price is reached at which they “sell all bonds”.
At each preceding step, One or more buyers express interest in terms of how many (0 < X < all) bonds they want at that price.
At the previous rate (6.29%?) they weren’t all sold, so went to 6.3% – at which price the number wanted by buyers exceeded supply.
But we don’t want to borrow all that much, at that rate..

I was under the impression that the auction system works in the way John described. So it is possible that demand at 6.3% was twice the number of bonds supplied but demand at every level below that rate was insufficient to clear the supply. 2x over demand in that structure is not remarkable and if it were it implies that the government is selling bonds at a yield that is higher than investors were willing to accept.

On the bond calculation, the theory seems right, but in reality I suspect that if/when the market does fear default, the yields would jump way way higher than 6%. Imagine a bond investor saying, well I can get 6% on a b bond, 12% on a Greek one and x% on a Spanish one. These have some probability of default and they eAch have different support backstops pin the event of possible stress, so go for what is judged to be the best return for the equivalent risk.

Not borrowing, particularly while the market is so bad, is surely an option.

Seize all deposits, temporarily, like income tax is temporary, while Napoleon ravages the royal families of Europe. The owners will get an enhanced deposit rate, far lower than the market rate.

One extreme!

Issue i o u s to those to whom we owe money, as in California but on an Irish/Icelandic scale!

Remember TINA! Got to borrow today and tomorrow and the day after. Challenge that!

Karl,
Why is a 50% recovery rate kinda low? Do we have any evidence on whats the norm or whats likely? How do we know its not kinda high? The statement that the markets think a default is “likely as not” looks, based on what you say, a bit dodgy.
Your probability of default over 10 years is based on the probability of default in any one year to the power of ten. This assumes they are independent, I think? But they can’t be since if you default in year 5 you don’t get to default in year 7. Shurely shome mishtake?

The setting of the price is designed to continue to devalue the fiat currency known as the Euro. Ireland is at the mercy of a rigged market, but one that is also “known” to be reasonable. In a little while, a few years, matters may alter significantly, when the 12.5% CT rate disappears as part of a rescue package for Ireland.

No more easy rides at the expense of the German Hausfrauen!

Shame to waste a good crisis!

It is possible to rig a market when both buyer and seller are later merged into one. The net cost of this deception will be left with the Irish taxpayer. The other peripheral economies will also help in this way. And German exports get a big boost, too!

Keven Denny:
[quote] “Why is a 50% recovery rate kinda low? Do we have any evidence on whats the norm or whats likely? How do we know its not kinda high? The statement that the markets think a default is “likely as not” looks, based on what you say, a bit dodgy.
Your probability of default over 10 years is based on the probability of default in any one year to the power of ten. This assumes they are independent, I think? But they can’t be since if you default in year 5 you don’t get to default in year 7. Shurely shome mishtake?” [/quote]

I think he calculated the probability of NOT defaulting by raising it to the power of ten. Of course, in order to not default, Ireland must not default in all ten years. The probability of defaulting then is just 1 minus that probability of not defaulting.

@karl

A question for you (and everyone). Why is ‘Ireland’ paying close the 6.5% for long term money when it could borrow from the Stability Funds at lower rates?

If the government is ‘doing’ what the ECB/IMF desire (so the various propagandists imply), why not just be sensible and borrow cheap money?

Doesn’t make sense to me but not much does since the bank guarantee.

@Sam
I posed much the same question under Philip Lane’s post on Ciaran O’Hagan. There is a very helpful response by Bond.

Even allowing for the deep and profound disappointment of many posters and media commentators that the bond auction went so well yesterday, they need to brace themselves for the possibility of even worse news from bond auctions within the next year or so. By worse, I mean, of course, better. Mob psychology in markets, any markets, often leads prices to unrealistic, unjustifiable and unsustainable levels. Look at oil prices, 150$ a barrel in July 2008 – $30 a barrel in March 2009. Neither extreme was realistic, justifiable or sustainable, but media-driven mob psychology took the prices there. These people are basically gamblers and the bond prices are the equivalent of bookies’ odds. Media comment often leads to gamblers getting it wrong. Kilkenny were 1/3 on and Tipperary 3/1 against. We all know that the mob on the streets believes that there is a significant chance of a default occurring. That’s why bond prices are high. How could they believe otherwise given the weight of uninformed media comment? Informed comment says the opposite. Witness recent articles by Donal O’Mahony and Ciaran O’Hagan. Even WilliamTheOptimist Buiter, who is quoted as a sage in Karl Whelan’s introduction to this thread, says it. This is what he said yesterday. Its in the following link, as no doubt some will think I made it up.

http://www.wtop.com/?nid=111&sid=2053376

“Citigroup’s chief economist, Willem Buiter, said the premium being demanded on Irish bonds remains “ridiculous,” given Ireland’s commitment to budget-cutting and its strong cash reserves. He said Irish treasuries should be trading within a percentage point of German rates if what he called irrational market fears could be eased.”

Note the word ‘irrational’. Look it up in the dictionary.

People can argue this same stuff to and fro, every day, until the cows come home, if they haven’t allready. But, at the end of the day, it all comes down to who people choose to believe. Its a free country, they can believe who they like. If people believe that David McWilliams, Morgan Kelly, Constantin Gurgdiev and Brian Lucey are the fount of all wisdom, and that William Buiter, Donal O’Mahony and Ciaran O’Hagan are talking through their rear ends, then by all means let them wallow in misery, and begin preparations to camp out at Dublin airport to cheer on the IMF men, whose arrival they’ve been longing to see for years, if not decades. But, if they believe the opposite, they’ll take a more optimistic view.

JTO

I think you are setting yourself up for a fall if you place one club of soothsayers above another. They all make calls, mostly wrong. As the saying goes, Dr X has predicted 8 of the last 2 recessions.
Who knows which set will be judged right in 18 months time. As you & Simpleton would say if the global economy recovers, in all probability we will get through crisis, if it does not we will default. I think the odds favour the benign outcome but the margin is narrower than you think.
If you offered me 10/1 in a tenner on a debt restructure before the Centenary of 2016, I would bite your hand off. I think the evens implied in Karl’s model might be a bit of a lay.

@ JtO: Its different strokes for different folks John. Who’s to know who is right or wrong in this situation. Guess they both are, simultaneously, and at the same time, so to speak.

However, back on planet earth. Aggregate economic activity (aka: growth) has to increase, annually and incrementally for us to exit this economic and financial mess. Now this is where the real problem lies.

This ‘growth’ business mandates two essential complements: credit and energy (in readily accessible forms and at a pecuniary cost that is repayable out of … … you guessed it, future income). If either credit or energy gets a tad short, then growth falters, hence future income falters. That’s it!

This is our predicament. Our future income stream is under significant threat. Our (western developed) economies are essentially showing a flat trend-line of aggregate economic activity, as is total world crude oil production. Reckon there might be some correlation (causation even)?

Without that annual, incremental increase in aggregate economic activity we cannot repay the debts we are incurring. Hence, default (or inflation more like) is inevitable. In the meantime the unfortunate citizen, taxpayer and non-taxpayer alike, will have their incomes reduced, and this will … … Jeeze, where did I hear this whinge before!

I mentioned yesterday that many contributors and commentators on this site were staring fixedly in the wrong direction. I repeat this assertion. And something else comes to mind. How is it that only two or three commentators to this site have ever mentioned the FIRE (Finance, Insurance + Real Estate) economy? Are the remainder unware of its existence? Or perhaps they are aware, but believe it is not relevant? Who knows. Be nice to know the answer though.

Brian P

Today I choose to go with JtO.

But Alchemist’s questions had occurred to me overnight.

What’s the downside to accessing the Stability Fund?

@BW
+1

But where do you ever see the FIRE economy discussed in mainstream discourse ? Have you come across the work of Harry Magdoff and Paul Sweezy ?

@SC

I could imagine bond prices falling significantly which would be very bad news for the banks and insurance companies holding them. It would probably be interpreted as a bad sign for the wider eurozone which isn’t in the best of health. Yields on the other PIGs’ bonds would probably rise. It might be a trigger for something worse.

@Tull McAdoo

You should be a bookie. Maybe you are.

If Paddy Power was giving odds on all this stuff, I’d be down there like a shot.

Meantime, while all the focus was on Ireland yesterday, the UK borrowing figures for August came out. Their current budget deficit was 21pc higher in August than in August 2009 (up from from £11billion to £13.3billion). In Ireland it has stabilised, which is nowhere near as good as falling but better than rising. And the reason in the UK was runaway government spending, the legacy of Gordon Brown, up by 11pc in August compared with August 2009. No wonder the UK ratings agencies are picking on Ireland. Takes the heat off.

If you are willing to give me odds of 10 to 1 on an Irish default I will act as bookie for you.

@JohntheO
“No wonder the UK ratings agencies are picking on Ireland.”
There are no UK ratings agencies. There’s a French one and some American ones. There’s also a Chinese one, perhaps you should chat to them?

There’s a chap I know who’s always looking for money. He’s a nice chap who will do his best to pay it back.
I’m a bit worried about him though because he’s had a big income cut. He’s coming to me now looking for more cash.
What should I do:
a) lend at the same rate as before because if I make the rate too high he will not pay me back at all
b) lend at 4% because even if he defaults I’ll have made some cash anyway.
c) lend at over 6% because even if he can’t afford to pay me back, his friend -Jean Claude will pay me back for him
d) not lend to him at all?

The background presence of the ECB bailout is actually making borrowing more expensive (not less).
Worse case scenario without it would be forced restructuring.
The bailout fund should be availed of up front and not as an insurance policy for bond marketeers.

@ Kevin\Tuna

The fish has it right. I calculated the annualised probability of not defaulting and to not default for ten years, that event has to come up ten times in a row.

Now in reality, the default rate isn’t constant across the ten years. One can extract different estimated default rates off different time horizons. I haven’t done that but I think they’d show the most likely defaults occuring at over a three year horizon, i.e. we’d be unlikely to default over the next 3 years thanks to the EFSF.

JohnTheOptimist

fine illustration of the head in the sand attitude taken by FF

btw I would bet that the man on the street is not aware

that we are considered riskier than ukraine, pakistan, iraq (ffs like!) and dubai

http://www.cmavision.com/market-data/#riskiest

at this point of time

when the default comes yee all be singing “oh it was unexpected” 🙁

The approach enunciated by Karl Whelan, in estimating the expected default, is simply wrong, in my opinion.

It focusses only on bond coupons and ignores the repayment of principal at the end of the bond’s life. Yet the principal repayment is the largest cash inflow associated with a bond.

Inclusion of that factor brings the expected default haircut (not probability of any default) down from around 50% to around 30%.

That’s a big difference.

@ JohnTheOptimist

Morgan Kelly has credibility because his analysis may have been viewed as incendiary or alarmist by those who didn’t want to hear inconvenient truths but most of it has been spot on.

What he said in the Prime Time interview on Sept 30, 2008 with Brendan Keenan, should be viewed as a classic.

I think we are right to remain focused on the fundamentals – Bond markets will just follow the trail of recovery / carnage that the real economy leaves.

As Cowen & Co. are quick to point out, much of the recovery for a small open economy like Ireland’s will be determined by the intn’l markets BUT, following the wise proverb of Reinhold Niebuhr, we must have the wisdom to distinguish those factors that ARE under our control and then find the strength to act on them.

What can we control?

Continued budget austerity – this will depend on public acceptance of the govt and belief in the doctrine that “we are all in it together”. Another round of voluntary pay cuts (linked to budget conditions) for politicians might help here. Otherwise, sacking a few bankers would not go astray…the people want a bit of blood.

Enforced losses to bondholders – Whatever it takes to legally sock it as much as possible to the bondholders will not only save us money, but help us sell budget austerity to the ultimate underwriters of Irish sovereign debt, the Irish people.

Lower rents and land values – Rents are stabilising and this is bad news. Much of the problem comes back to the enormous surplus of empty dwellings languishing off the market. As I have argued many times before, property taxes help bring land to its highest and best use. It is the only really effective way of punishing speculators. It will push land onto the market and force down rents. Also, the banking policy is bad here, because our zombie banks are allowing mortgage payment rollovers etc. in order to kick the can down the road (to draw their inflated salaries longer?). But failure to default on inflated mortgages simply shores up unsustainable property values, keeping rents high!

@ Sam

Imagine a house for auction by sealed bids. Highest bid is 500k. There are also 10 bids for 400k. Auction 9 times oversubscribed. Means very little.

@ Karl

Risk Aversion. No-one is picking up on that. It is absolutely key. Imagine you have just retired and you look with smug satisfaction at your million pound pot built up over a lifetime career. Some bookie offers you the toss of a coin on your whole pot. What odds would you want to take it up? Even money if you are risk neutral but you most certainly would not be RN. Would you accept 10/1 odds? I wouldn’t.

The same thing is happening with these sovereign bond auctions. For the sort of people who want sovereign bonds the prospects of default, however faint, are absolutely chilling. They will demand a risk premium far and above the rationally assessed probability of the default. Unfortunately there is no way of quantifying this risk premium and thus no way of knowing what the consensus view of the mathematical probability is.

I use a slightly different formula to calculate the same thing

1-EXP(-SPREAD X TIME / (1-Recovery Rate) )

@ Cormac

“The approach enunciated by Karl Whelan, in estimating the expected default, is simply wrong, in my opinion.

It focusses only on bond coupons and ignores the repayment of principal at the end of the bond’s life. Yet the principal repayment is the largest cash inflow associated with a bond.”

Nope, I’m not ignoring the principal repayment — that would be a pretty big omission indeed if I were doing so.

The return in the bad outcome is (c-1). This is negative because you’re losing your principal. If c=0 (full default) the return is -1 because you lose all your principal.

@DE

33% probability of defaultbefore 2016=2/1 in bookies language, do you think that is a good bet?

Remember there are things that the authorities can do that may skirt around the issue or at least cause an argument about whether or not there was a default.

@ Kevin

“Why is a 50% recovery rate kinda low? Do we have any evidence on whats the norm or whats likely? How do we know its not kinda high? The statement that the markets think a default is “likely as not” looks, based on what you say, a bit dodgy.”

Well most economic calculations are kinda dodgy! It’s art not science.

So here’s my justification. I think about this as follows. Any default will probably occur if the debt-GDP ratio is about 130%-150% of GDP. And it will probably take place with the EU and IMF being involved in negotiating the terms — if it’s to get to that we’ll have passed through EFSF purgatory first so we’ll owe them a big chunk of money. All this points to a negotiated restructuring rather than a full-scale default.

A 50% haircut would put us back in a sustainable 65%-75% range. But I think the evidence shows this might be a bit high.

The most cited paper on this right now is The Economics and Law of Sovereign Debt and Default — a JEL survey by Ugo Panizza, Federico Sturzenegger, and Jeromin Zettelmeyer

sites.google.com/site/upanizza/psz_fin1.PDF

They say:

“Consistent with the behavior of Enderlein, Müller, and Trebesch’s procedural index, actual creditor losses in the 1998-2005 period show a high degree of variation, from very high losses in Argentina’s 2005 restructuring—about 75 percent—to low losses in Uruguay’s (2003) external restructuring, in the order of 13 percent (Sturzenegger and Zettelmeyer, 2007b, 2008). Furthermore, there is a strong, albeit not perfect, correlation between investors’ losses and the procedural index (Figure 3). Finally, estimates of debt forgiveness based on face value reductions and interest forgiven compiled by Benjamin and Wright
(2008) for 90 default episodes that were initiated between 1979 and 2005 suggest that the defaults that began before 1995 involved debt write downs that were more than twice as big than those of defaults that began after 1995 (the “haircuts”, in Benjamin and Wright’s definition, are about 22 percent for the more recent group of defaults and about 45 percent
for the pre-1995 group of defaults; restricting the latter group to the Brady deal countries leads to about the same average haircut).”

By Post Author

@Karl,Cormac

I used the trusty old spreadsheet goal seek. Assuming default only happens at maturity I work out the 10 year probability of default to be almost exactly 40%.

@ Karl

50% recovery (ie 50% nominal default) seems high when you consider the wealth still existing in this country. Cant see many international investors agreeing to that. Assuming that level of default would also seem to make for an easy assumption that Greece and Portugal would also default, and that Spain would not be far behind. Faced with this type of chain reaction you start to bring up lots of other likely scenarios – ie massive QE being the only way out.

The yield on the 10- year Portuguese bond climbed 2 basis points to 6.36 percent before the government auctions as much as 1 billion euros of 2014 and 2020 securities. – bloomberg

Irish 10yr – 6.29%

losses ytd on 10yr irl -10.73%

no wonder the people jto quotes are talking the yield down- they needtheir money back.

@ Eoin

“50% recovery (ie 50% nominal default) seems high when you consider the wealth still existing in this country.”

You mean 50% recovery seems low, right? That they’ll get more than that back.

Right, as I noted above, I’d agree with that. However, my reason for using the 50% recovery rate was to show that even if you let a big anticipated haircut account for much of the spread, the 10-year default probability still comes in above a half. If people really think the worst case scenario is that they’d only lose a third, then they must be anticipating default as even more likely.

Credit-default swaps to insure Portuguese sovereign debt rose 12.5 basis points to 385, the highest since May 7, while contracts on Ireland climbed 26 basis points to a record 466.5, according to data provider CMA

The Portuguese are paying more than us today on 10 yr but the cost of insuring our bonds is soaring. Odd. what formula dothey use?

Karl,
Aren’t you ignoring the discounting due to inflation or does the RF incorporate both inflation and risk-free return? So can we say that German bunds are predicting that the 10-year average inflation in the Euro zone will be about 1.5% p.a. (assuming a 1% risk-free return)? If so, that is bad bad news for Ireland which desperately needs to grow/inflate its way out of debt.

@ Garo

re inflation

to that end the suggestion last night from the Fed on more QE, and the likelihood of the BoE following suit if the Fed goes, are very good news for Ireland (accepting that the curreny could undo much of the gains).

Hopefully the ECB and EU are listening.

The spread implies 33% and I think the reality is a small bit less but not much point placing a bet unless there is some margin in it for me, 🙂

@Karl Whelan

‘Well most economic calculations are kinda dodgy! It’s art not science.’

At last! An economist who explicitly recognises ontological constraints and limits of this ‘dodgy’ discipline … and empirical evidence of some emergent ‘wisdom’ …. doubt though that you could get a line such as this past the ideological gatekeepers in AME! ‘Spose we might term this The Aesthetic Turn in Economics … more please!

“I don’t say everything – but I paint everything” Picasso

@ DE

You don’t expect me to quote you 7/2 when the market is 2/1. I would call that an insult and a code violation. As a matter of interest, what CDS spread is implied by a 22% default prob over 5 years. I only have pass maths

Eoin,
Two things occur to me. First, the ECB was the slowest off the blocks in 2008 when it came to easing and there is little reason to expect it will not be the same in this round. Second, if you expect QE and inflation, are you telling me that Government bonds are not a good buy?

@Jto

why do you presist in ignoring Morgan Kelly and McWilliams. Kelly called the property crash and the Bannking crisis and calls for a quick resolution of this crisis by defaulting. With McWilliams, he was on the money too and his Sunday Business Post article last sunday was an eye opener. He was a Bond trader in his youth, has experience. So what is your beef?. Your making it all so personal, play the ball not the man.

@ Garo

(a) agree about ECB being slow off the mark, but at some stage i assume the discussion will at least come up. We can only hope on the decision making at that point.

(b) QE is initially good for bonds – its the central bank buying up the market. Longer term any inflation that is caused obviously erodes their value. As we’ve seen in the US, large amounts of QE do not necessarily create inflation at the short end, and even the long end doesn’t envisage it right now. Also, inflation would be worse for bunds than Irish gilts if the point of inflationary policies is to ease the indebtedness of a country like Ireland – there’s zero upside for Germany from a debt point of view, there’s quite clear upside for Ireland which is suffering from a creditworthiness deficiency.

@JTO
“Look at oil prices, 150$ a barrel in July 2008 – $30 a barrel in March 2009. Neither extreme was realistic, justifiable or sustainable, but media-driven mob psychology took the prices there.”

That’s a naive view of the oil bubble crisis. A more credible explanation is that it is part of an orchestrated campaign by commodity speculators – in particular GS to deliberately inflate the price. Matt Taabbi article has a to my mind pretty coherent analysis of that and other deliberately inflated bubbles. It should be a sad day when Rolling Stone political commentators have a better grasp of what is going on than the economics experts. It is not just irrational behaviour of the markets but deliderate manipulation. I suspect the same applies to the Irish bond yields.

http://www.rollingstone.com/politics/news/12697/64796?RS_show_page=5

“In the beginning of 2008, Arjun Murti, a Goldman analyst, hailed as an “oracle of oil” by The New York Times, predicted a “super spike” in oil prices, forecasting a rise to $200 a barrel. At the time Goldman was heavily invested in oil through its commodities trading subsidiary, J. Aron; it also owned a stake in a major oil refinery in Kansas, where it warehoused the crude it bought and sold. Even though the supply of oil was keeping pace with demand, Murti continually warned of disruptions to the world oil supply, going so far as to broadcast the fact that he owned two hybrid cars. High prices, the bank insisted, were somehow the fault of the piggish American consumer; in 2005, Goldman analysts insisted that we wouldn’t know when oil prices would fall until we knew “when American consumers will stop buying gas-guzzling sport utility vehicles and instead seek fuel-efficient alternatives.”

But it wasn’t the consumption of real oil that was driving up prices — it was the trade in paper oil. By the summer of 2008, in fact, commodities speculators had bought and stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that speculators owned more future oil on paper than there was real, physical oil stored in all of the country’s commercial storage tanks and the Strategic Petroleum Reserve combined. It was a repeat of both the Internet craze and the housing bubble, when Wall Street jacked up present-day profits by selling suckers shares of a fictional fantasy future of endlessly rising prices.

In what was by now a painfully familiar pattern, the oil-commodities melon hit the pavement hard in the summer of 2008, causing a massive loss of wealth; crude prices plunged from $147 to $33. Once again the big losers were ordinary people. The pensioners whose funds invested in this crap got massacred: CalPERS, the California Public Employees’ Retirement System, had $1.1 billion in commodities when the crash came. And the damage didn’t just come from oil. Soaring food prices driven by the commodities bubble led to catastrophes across the planet, forcing an estimated 100 million people into hunger and sparking food riots throughout the Third World.”

@ Eoin

“There’s zero upside for Germany from a debt point of view..”

If you assume that there the unconditional polictical backing of the eurozone is real than engaing in some style of eurozone QE sooner rather than later when things have deteriorated even more would present upside to German debt.

@ AMc

kinda ironic? Eh no, i agree with him on a lot of stuff, and i think he has an excellent way of explaining how the markets work in laymans terms. Thats why I have recommended reading him. Doesn’t mean i have to agree with him on everything. That would be called blind loyalty. One hopes you are not afflicted with that condition. For the record, i think GS have done lots wrong and there’s tons of scope to criticise them. However, blaming them for every financial calamity that has befallen the markets in the last few years seems to stretch reality into conspiracy-theory land a little too much for any rational debate to consider. They’ve become the punchbag to blame all our ills on, regardless of the real cause. The “GS caused the oil crash” story essentially amounts to “GS told everyone it was going up” (which it did) and then either didn’t bother to alert everyone or just didn’t realise that it was going back down. Wow, the bast*rds…

GS are a symptom of the market’s problems rather than a cause. As Michael Lewis himself said (in a far more serious and less sarcastic article than yours):

“Q: Would the world be better off without Goldman Sachs? It seems that everywhere we turn that they are involved in some kind of sketchy, not really illegal, but gray-area-type behavior.

A: Yes, the answer is yes. The world would be better off without Goldman Sachs, and I don’t think it is just Goldman Sachs the world would better off without. If you waved a wand and wiped out Goldman Sachs, someone would step in and occupy that place. I think the world would be better off without the idea that Goldman Sachs embodies, which is that financial manipulation is a legitimate way to get really rich.”

Lots of people do what GS do, they just happen to be better than everyone else. They’re far from evil, unless you think the entire financial system is intrinsically evil.

@A M McGrath

Our own Greens appear to agree with the GS view of an oil price supercycle. I wonder were they long as well. IIRC, Deputy Cuffe’s trust fund had some exposure to big oil at one time.

@tull
22% would imply a CDS spread of about 300bps.

It is a binary bet tull so every bookie is going to quote odds well off fair value, otherwise they would be out of business.

@Eoin
A reduction in levels of sarcasm is indeed always welcome – even from your good self. Seems like we are not exactly poles apart in any case. I will levae you with a quote from Paul Krugman which I do agree with although I might go further:
“..the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors. And if we don’t lower the boom on these practices, the racket will just go on.”

@DE
It is priced at 2/1 due to weight of money. It has become a consensus long that we are going to default. The difference between this & a horse race is that no amount of money can make a horse win but rising pressure on yields could force us over the edge. perhaps it is more like a Cricket match.

@Aidan McGrath Eoin

Title of Chapter IV in J. K. Galbraith’s The Great Cra$h 1929 is ….

In Goldman, Sachs We Trust

Published in 1954 (methinks)

@JTO

If you had followed Davy’s and other stock broking houses including Deutche bank et al) advice and analysis over the course of the crisis you would have lost a lot of money.

If you had followed McWilly’s or Kelly’s you’d have done well.

Failing to advice their clients about the existence and consequences of what was, at very least in retrospect, a clear bubble in Irish property was, well, a failure to perform a basic function that people engage financial experts for. Anyone can buy into an exchange traded fund but they get expert advice at least in part to avoid disasters.

Irish stockbroking houses got it wrong. Wrong wrong wrong. They had Irish banks as buys the whole way down.

That was a huge call

Now you wish to paint the current conflict of views as some sort of showdown between two different views that will determine who should be listened to about the economy. But you seem to ignore the obvious previous test.

“If Paddy Power was giving odds on all this stuff, I’d be down there like a shot.”

Buy some Irish bonds and throw a bit of leverage at it.

If you had done that a month ago you’d be sitting on big losses. You like many analysts think you have a better view than the market on what the appropriate price of Irish debt

Brian P
Energy is available in abundance at competitive price. But the kleptocracy have a lock on oil and coal. Ever heard of SASOL? WWII Germany made synthetic oil from coal. Control of a market leads to wild price swings as has recently happened with oil. Think OPEC joining covertly with the 7 sisters! Geothermal is limitless. Spin off? No volcanoes, fewer earthquakes of massive size, more earthquakes of small size.

The real problem for this cartel is China and India. They frighten them. The west has been living off cheap resources from the rest of the world for a long time. Colonialism was an obvious system, replaced by fiat currencies.

Fiat currencies default all the time by way of inflation. The idea now is to devalue the western currencies, devaluing the debts owed by them. Who has given money to these currencies? Pension funds, developing countries. They hope to have inflation again after the devaluation to further enable mild, non-reprehensible default.

They can get away with that as in the past, because people do not understand the real role of fiat currency. The Austrian school think that fiat currency is wrong, as it enables those who control it to make more than those who must use it. A moral viewpoint.

@James Conran
Yes I had the same question

@DE
I tried to see what the default probability would be using the equation

1-EXP(-SPREAD X TIME / (1-Recovery Rate) )

but was not sure how to interpret it. Using Karl’s numbers

p = 1-EXP( ( -(0.0630 – 0.0246) x 10) / (1 – 0.5) )
= 1-EXP( -0.384 / 0.5)
= 1-EXP(-0.768)
= 1-(-2.088)
= 3.088

So I’m clearly going wrong somewhere – how should it be done?

It would be much easier if Paddy Power did all the work…

@BG

exp(-0.768) gives you 0.464 -> 1 – 0.464 = 0.536

To get -2.088 it would be exp(+0.736)

Hi,

I understand your reasoning for p = (RR – RF ) / (1 –c + RR)

But because you build in assumption of 50% recovery rate in the weighted average above, you make your result depend on your assumptions, not on evidence.

The fact is there can only be one outcome, not a series of outcomes from which some average result can be defined. There could be a scenario where the recovery rate is 0 and the probability of a return is minus.

0.493 probability of a default based on an assumed 50% recovery rate is like saying…. its likely to rain today based on evidence that the probability of rain today is 50% 🙂

I supose the term “implied” default probability, means just that. It is the probability that is implied from bond yields. It doesn’t necessarily mean there is any historical evidence that that is the actual probability of default.

I’m not an expert in this field but a quick google search turns up this paper:
http://www.rotman.utoronto.ca/~hull/downloadablepublications/CreditSpreads.pdf

which suggests that the real probability as taken from historical data is only one tenth of the probability as calculated from bond yields.

@DE
does it work now?
also here is another graph (492 kB pdf); it is a contour plot of spreads and recovery rates.
What you can see (hopefully) are the combinations of spread and recovery rate that give a large default probability.
I can’t say how reliable that equation is (I know no econophysics), or how to estimate likely recovery rates, but at least with this you can say for what range of recovery rates is a default likely for this equation.

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