Sunday, February 22, 2009

Germany to the Rescue! - Update I

Now a peak at the CDS spreads again (hat tip to BL). To my earlier post (here) see the chart below: Gheez - we have Irish CDS reaching toward Philippines around mid February...
Of course, per Davy (here) there is no need to panic. “The risk of Ireland not being able to meet ongoing debt payments over the next few years is very low.”

Low? Hmmm.

Ireland government bond CDS at 3.4% and a recovery rate of 40-50% is equivalent to a risk-neutral (frictionless markets etc) default probability of CDS/(1-RR)=3.4%/0.6 = 5.67 pa or (1- (1-0.0567)^5)=25.3% cumulative default probability over 5 years. For 50% recovery rate, the latter figure is 29.7%.

Now, investors are risk averse, not risk neutral, and the Irish bond market is not exactly frictionless which can push the above probabilities down, although we do not know by how much.

What is, however, not accounted for here is the potential downside to the recovery rate - the amount that can be expected to be recovered should a sovereign actually default. For now, the markets price in a 40% recovery, implying that in the case of a default investors can expect to get 40c on each Euro back. But how realistic is this?

One recent experience with sovereign default shows that in the case of Argentina in 2000-2002 (see Andritsky, J (2005) Default and Recovery Rates of Sovereign Bonds, The Journal of Fixed Income, September 2005)
" Uncertainty about the expected recovery value is a main caveat when pricing credit-contingent claims in reduced-form models...The resulting recovery value estimated from Argentine global bonds starts out above 50% and falls to 25% after default."
So back-track from the above to today's Ireland Inc scenario and, suppose the recovery rate of 60% today implies a recovery rate of 30-40% at default and the current probability of default over 5 years of
(1-[100-CDS/(1-RR)/100]^5)=36%... Nothing to worry about, folks, then - in plain English the above means that if Ireland Inc is any better than Argentina (the country that routinely and with frightening regularity takes foreign investors to the cleaners), our CDS levels today might be consistent with an equilibrium cumulative default odds of over 1 chance in 3.

But hold on, if the CDS rates are not a decent measure of implied default probability and a purely speculative tool instead (as our Nobel-prize contesting gurus from Davy, the DofF and CB keep telling us), why should the CDS data track closely the yield spreads? Maybe because they 'kinda feel so, man!' or maybe because the speculators in both markets are all in some global conspiracy club (wearing Venitian Canvivale masks and speaking in secret signs), or maybe, just maybe, both markets are really not buying the DofF-led and Davy-repeated story of 'no risk of default for Ireland Inc'.

Either both, the markets for CDS and Irish bonds are wrong, or Davy and the Government are. Take your pick.

No comments: