More on Sovereign Defaults
I blogged about sovereign defaults in November last year. Since then, I have been reading a lot about sovereign defaults with a focus on defaults by sovereigns who were great powers at the time of default. I have also been doing some reading about credit default swaps on sovereigns.
Turning first to sovereign defaults, I went back to the famous Stop of the Exchequer by Charles II of England in 1672. I regard Charles II as one of the greatest kings of England (one Royal Society is worth a few sovereign defaults!) What struck me was the brazen manner in which the sovereign proclaimed his default:
... his Majesty, being present in Council, was pleased to declare that ... his Majesty considering the great charges that must attend such preparations, and after his serious debates and best considerations not finding any possibility to defray such unusual expenses by the usual ways and means of borrowing moneys, by reason his revenues were so anticipated and engaged, he was necessitated (contrary to his own inclinations) upon these emergencies and for public safety at the present, to cause a stop to be made of the payment of any moneys now being or to be brought into his Exchequer, for the space of one whole year ... unto any person or persons whatsoever by virtue of any warrants, securities or orders, whether registered or not registered therein, and payable within that time, excepting only such payments as shall grow due upon orders on the subsidy, according to the Act of Parliament, and orders and securities upon the fee farm rents, both of which are to be proceeded upon as if such a stop had never been made.
... and that in the meantime ... his Treasury be required and authorized to cause payment to be made of the interest that is or shall grow due at the rate of six pounds per cent, unto every person that shall have money due to him or them ... so postponed and deferred.
English Historical Documents, 1660-1714 By Andrew Browning, p 352
Next I turned to the US abrogation of the gold clause in 1933. Investors in the US protected themselves from the debasement of the currency by demanding a clause requiring repayment in gold or in coins of specific weight and purity of gold. In 1933, the US abrogated this clause with a resolution that is again striking in its brazenness:
House Joint Resolution 192, June 5, 1933
Joint resolution
To assure uniform value to the coins and currencies of the United States and currencies of the United States. Whereas the holding of or dealing in gold affect the public interest, and are therefore subject to proper regulation and restriction; and
Whereas the existing emergency has disclosed that provisions of obligations which purport to give the obligee a right to require payment in gold or a particular kind of coin or currency of the United States, or in an amount in money of the United States measured thereby, obstruct the power of the Congress to regulate the value of the money of the United States, and are inconsistent with the declared policy of the Congress to maintain at all times the equal power of every dollar, coined or issued by the United States, in the markets and in the payment of debts.
Now, therefore, be it Resolved by the Senate and House of Representatives of the United States of America in Congress assembled,
That (a) every provision contained in or made with respect to any obligation which purports to give the obligee a right to require payment in gold or a particular kind of coin or currency, or in an amount in money of the United States measured thereby, is declared to be against public policy; and no such provision shall be contained in or made with respect to any obligation hereafter incurred. Every obligation, heretofore or hereafter incurred, whether or not any such provision is contained therein or made with respect thereto, shall be discharged upon payment, dollar for dollar, in any coin or currency which at the time of payment is legal tender for public and private debts.
These measures were challenged in the US Supreme Court which upheld them stating (Norman v. Baltimore & O.R. Co., 294 U.S. 240):
We are not concerned with their wisdom. The question before the Court is one of power, not of policy.
Contracts, however express, cannot fetter the constitutional authority of the Congress. Contracts may create rights of property, but, when contracts deal with a subject-matter which lies within the control of the Congress, they have a congenital infirmity. Parties cannot remove their transactions from the reach of dominant constitutional power by making contracts about them.
The Supreme Court also upheld the abrogation of the gold clause for the government’s own borrowing. The concurring opinion of Justice Stone in Perry v. United States, 294 US 330) was unusually blunt:
... this does not disguise the fact that its action is to that extent a repudiation of its undertaking. As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion, announced for the Court, that in the situation now presented, the government, through the exercise of its sovereign power to regulate the value of money, has rendered itself immune from liability for its action. To that extent it has relieved itself of the obligation of its domestic bonds, precisely as it has relieved the obligors of private bonds.
Finally, I looked at the world’s leading serial defaulter. “Spain defaulted on its debt thirteen times from the sixteenth through the nineteenth centuries, with the first recorded default in 1557 and the last in 1882.” (Reinhart, Rogoff and Savastano, “Debt Intolerance”, Brookings Papers on Economic Activity, 2003(1), 1-62)
I was most interested in the defaults of Philip II, who “failed to honor his debts four times, in 1557, 1560, 1575 and 1596.” (Drelichman and Voth, The Sustainable Debts of Philip II: A Reconstruction of Spain’s Fiscal Position, 1560-1598)
Drelichman and Voth find that:
Contrary to the received wisdom, we show that Philip II’s debts were sustainable for most of his reign. ... Overall, Habsburg Spain’s fiscal discipline was similar to that of other hegemonic powers, such as eighteenth-century Britain or twentieth-century America.
Philip II managed to run a primary surplus in every year of his reign for which we have data. The king never borrowed to cover interest. ... the average primary surplus increased throughout the period as the Crown strove to deal with the increasing interest payments.
With this as background, buying CDS protection on the leading sovereigns of today does not appear to me to be the madness that Krugman claims it to be: “A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?”
First of all, Alea blog points out “No, they are not crazy, the contracts will be honoured: 100%, guaranteed, for a simple reason, most sovereign CDS are packaged in fully funded credit derivatives first-to-default credit linked notes, therefore the protection buyer gets the cash upfront and is not exposed to the protection seller credit risk.”
He also points to the prospectus of one of these credit linked notes under which a Belgian bank could end up buying credit default protection against the Belgian government (and other governments) from a Belgian dentist. It would work perfectly. Of course, the Belgian dentist is exposed to default risk of the bank, but if the sovereign is solvent, it would probably backstop its bank and the risk of default is low in today’s moral hazard filled world.
Second, Credit Trader points out that the denomination of the CDS in Euros increases the value of the CDS significantly because it effectively becomes a quanto derivative. Third, the inclusion of the restructuring event as a default event makes a world of difference.
One of the scenarios that I consider plausible is that similar to the gold clause repeal, the US could decide that inflation indexed treasury bonds (TIPS) would be redeemed in nominal dollars and not inflation indexed dollars. I am not a lawyer, but I would imagine that this would pass master with the US Supreme Court just as the gold clause resolution did. I would also imagine that such an action would amount to a default event (restructuring) that triggers the CDS payment. That is why as I argued back in November, having the contract governed by a non US law is very useful.
Today, TIPS are a very attractive asset if investors could protect themselves against the US defaulting on its indexation obligation. Buying TIPS and then buying CDS protection on the US government appears to me to be a very sensible trade and not madness at all.
Posted at 5:03 pm IST on Sun, 15 Mar 2009 permanent link
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