Download Diapositiva 1

Umberto Cherubini
University of Bologna
Conference
Sovereign Credit Risk and Government Guarantee to Financial
Institutions: Issues and Prospects
Bank of Italy, July 6 2011
Papers
Baglioni A. – U. Cherubini: Marking-to-Market
Government Guarantees to Financial
Systems: An Empirical Analysis of Europe,
http://ssrn.com/abstract=1715405
Baglioni A. – U. Cherubini: A Theory of
Eurobonds, work in progress
2
Outline
• Motivation
– Lessons from the crisis
– Banks and the public sector in the crisis
• Mark-to-market of Government guarantees to the financial
systems
– Probability of a systemic crisis
– Actuarial value of Govt insurance of a financial crisis
• Theory of Eurobonds
– A structural model of public debt
– An example of Eurobond financial engineering
– Effects on public debt cost of Italy and Spain
3
Crisis stages
1. Credit crisis: “subprime” mortgages were the trigger of
the crisis.
2. Counterparty and liquidity risk: no trust in neighbours, no
trust in assets (main theme of the crisis)
3. Accounting transparency crisis: fair-value accounting has
been a vehicle of contagion, “lite accounting” (borrowing
through SIV)
4. After Lehman default, the crisis moved from the banking
system to public balance sheets. Lehman was like a
nuclear experiment. The effects of the explosion have
not come to an end yet.
5. Some are considering a new nuclear experiment with
Greece. This would bring the crisis back to step 2 above.
4
Where did the crisis end?
• The crisis could end nowhere but in the only
balance sheet that is not computed at fair value,
namely Government and municipal entities
balance sheets.
• Bail-out from the Government: special purpose
interventions (see AIG, Fortis, and the like) and
general purpose committments
• Central bank intervention: quantitative easing, to
provide liquidity to the system and prevent
contagion.
5
“Monstruous siamese brotherhood”?
• In the aftermath of the 29 crisis the most famous Italian
banker, Raffaele Mattioli, founder of COMIT (BCI) denoted
“mostruosa fratellanza siamese” the evolution of the
relationship between banks and corporate clients. The
“physiological symbiosis” typical of “universal banking”
(that is lending and providing risk capital) had brought, in
a period of credit crisis, the banks to take control of
industrial firms.
• Today, the same “monstruous siamese brotherhood” is
looming in the relationship between Government and the
banking system.
6
The “siamese brotherhood”
• Banks have exposures to Government. Once monetary
base was directly created by the central bank by lending
to Government. Now lending is intermediated by banks.
Government issue securities that are bought by banks in
the primary market and placed as collateral with the
central bank. Default of a Government would severely
jeopardize the banking system.
• On July 13 we will have the results of new stress tests of
the soundness of the banking system in front of a public
debt crisis ending with default. The old stress test tried in
September was only based on the value impairment of a
crash in the public debt securities market.
7
Fail or be rescued?
• The other face of “siamese brotherhood” is the implicit
guarantee offered by the Government to banks
• Too big to fail (or to big to save?). The debate is about
whether it is possible to allow big institutions (systemically
important financial intermediary, SIFI) to go bankrupt
• Taxation on SIFI: they would pay for insurance from the
public. Pros: makes moral hazard more costly. Cons: who
is SIFI? Any volunteer?
• Living wills: should (or could) big banks prepare their own
funeral? Pros: higher recovery. Reduces moral hazard
because makes default credible. Cons: how to plan
externalities? Can you be credible if you state that you will
walk into the grave on your own?
8
The value of the guarantee
• Dataset. Banks from 10 European countries taken
from the sample of the stress test of last
September, and for which we recovered CDS
quotes
• Methodology: we filtered the systemic component
for each country and we computed the value of
CDS insurance (paid upfront), that should be paid
by each country to buy protection against a
systemic crisis.
9
Marshall Olkin copula
• Marginal survival probabilities
• P(1 > T) = exp(– (1 + 12)(T – t )) = u1
• P(2 > T) = exp(– (2 + 12)(T – t )) = u2
P(1 > T, 2 > T) = u1u2 min(u1-1 u2 - 2)
with i = 12 /(i + 12)
• This is known as Marshall Olkin copula
• If i =  for all i, this is called exchangeable
Marshall-Olkin, or Cuadras-Augé copula
10
Marshall-Olkin factor model
• The idea of Marshall Olkin distribution is that
different shocks bring about defaults of
subsets of names.
• The problem is that there may exist an
arbitrarily large number of shocks and this
makes calibration of the model very difficult.
• Factor model specification
n
   i  123.... n
i 1
11
Cuadras-Augé Filters
• Call m the cross-section average intensity
• Given 1/ (average of inverse Kendall’s )
and 1/ (average of inverse Spearman’s ).
123... n 
2
1
1

m 123... n


4 1

3 1 1
3 




 m


12
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Italy
0,2
0,18
0,16
0,14
0,12
Govt
0,1
Systemic
0,08
Financial
0,06
0,04
0,02
0
13
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Spain
0,3
0,25
0,2
Govt
0,15
Systemic
Financial
0,1
0,05
0
14
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Portugal
0,4
0,35
0,3
0,25
Govt
0,2
Systemic
Financial
0,15
0,1
0,05
0
15
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Greece
0,7
0,6
0,5
0,4
Govt
Systemic
0,3
Financial
0,2
0,1
0
16
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Ireland
0,45
0,4
0,35
0,3
0,25
Govt
0,2
Systemic
Financial
0,15
0,1
0,05
0
17
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
U.K.
0,2
0,18
0,16
0,14
0,12
Govt
0,1
Systemic
0,08
Financial
0,06
0,04
0,02
0
18
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Netherlands
0,2
0,18
0,16
0,14
0,12
Govt
0,1
Systemic
0,08
Financial
0,06
0,04
0,02
0
19
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
France
0,14
0,12
0,1
0,08
Govt
Systemic
0,06
Financial
0,04
0,02
0
20
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Germany
0,14
0,12
0,1
0,08
Govt
Systemic
0,06
Financial
0,04
0,02
0
21
01/09/2010
01/07/2010
01/05/2010
01/03/2010
01/01/2010
01/11/2009
01/09/2009
01/07/2009
01/05/2009
01/03/2009
01/01/2009
01/11/2008
01/09/2008
01/07/2008
01/05/2008
01/03/2008
01/01/2008
Austria
0,4
0,35
0,3
0,25
Govt
0,2
Systemic
0,15
Financial
0,1
0,05
0
22
Portugal
Ireland
Italy
Greece
Spain
Germany
France
UK
Netherland
Austria
Table 5. Mark-to-market of the implicit guarantee to a systemic shock (bn euro)
Intensity
DP
LGD
Government Commitments
Liability Liability
Commitments
6,04%
26,06%
312,12
73,68
20
53,68
7,15%
30,05%
980,4
266,85
430
-163,15
2,65%
12,42%
2248,62
252,98
20
232,98
12,12%
45,45%
295,14
121,51
28
93,51
4,73%
21,06%
2068,08
394,57
329
65,57
0,94%
4,57%
4461,66
184,89
480
-295,11
1,36%
6,56%
4594,02
273,00
288,95
-15,95
2,07%
9,85%
5677,2
506,61
444,66
61,95
1,70%
8,15%
1330,2
98,23
200
-101,77
2,79%
13,02%
618,12
72,90
90
-17,10
Total
2245,23
2330,61
-85,38
23
600
500
Germany
y = 0,8025x + 52,877
R2 = 0,3876
U.K.
Ireland
Commitment
400
France
300
Spain
Netherlands
200
100
Austria
Greece
Italy
Portugal
0
0
100
200
300
400
500
600
Government Liability
24
The Government crisis, finally
Table 6. Bail-out Government liability and
Debt/GDP
Total
Liability/GDP
Debt/GDP
Portugal
121,76%
44,96%
76,80%
Ireland
227,17%
163,17%
64,00%
Italy
132,43%
16,63%
115,80%
Greece
166,26%
51,16%
115,10%
Spain
90,74%
37,54%
53,20%
Germany
80,88%
7,68%
73,20%
France
91,91%
14,31%
77,60%
UK
100,44%
32,34%
68,10%
Netherlands
78,13%
17,23%
60,90%
Austria
92,83%
26,33%
66,50%
25
Solutions of Government crisis
• ESM (European Stability Mechanism): will start in
2013, substituting EFSM. Dimension, 700 billions,
for 500 billions interventions. 80 billion paid in
cash required (half paid in 2013, the rest in
annuities)
• New stability pact: designing a road-map to debt
reduction, on top of the 3% budget deficits limit,
that represented the old stability pact
• Eurobonds: substituting part of the domestic debt
(40% or 60% of GDP) with European debt, senior
with respect to the domestic one, and jointly
guaranteed by the Governments of the Euro area.
26
A theory of Eurobonds
• The Eurobond proposal is based on three
ingredients
– Seniority: in case of default Eurobonds are impaired
only after domestic debt (junior) is swept away
– Cross-guarantee: Eurobonds are guaranteed by all
Governments of the Euro area
– Diversification: if primary surpluses are not perfectly
correlated, budget crises in some countries may be
balanced by surpluses in others.
27
Effects of Eurobonds
• Assume Eurobonds are designed so that they are
default free (we will see later how)
• Effects will be:
– Decrease of overall cost of debt (due to crossguarantee and diversification), with no increase of cost
for countries whose expected surplus is higher than the
European average
– Increase of the marginal cost of debt (due to the
hierarchical structure). Since domestic debt will be
junior with respect to Eurobonds, the cost of domestic
debt will be higher than the average cost of debt.
28
A structural model of sovereign debt
• Given a path of primary surplus, measured in
euros, S, the amount of debt in n years is
n
D0
1
DN 

v(t0 , ti )Si

v(t0 , t N ) v(t0 , t N ) i 1
• At time tN, default occurs if DN > DK, with DK a
default threshold (unobserved)
• Probability of default at time t0 is P(DN > DK )
29
Mathematics
N
 D0

1



P( DN  DK )  P

v
t
,
t
S

D

0

0 i
i
K
 vt0 , t N  vt0 , t N  i 1

N
N


 P D0 1  vt0,t N    i Si   N DK  D0   0  dividing by  vt0 , ti 
i 1
i 1


N


 P D0 RN   i Si  DK  D0   0 
i 1


N


 P D0 SRN  ASWN    i Si  DK  D0   0  or else...
i 1


N



Si 

  DK  D0   0  where f i are forward rates
 P D0 ASWN  D0  i  f i 

D0 
i 1



30
Distance to default
• Assume a dynamics of primary surplus. We speficy it in
terms of ratio to GDP: si = Si/Yi and di = Di/Yi.Assume a
simple model si = s + i, i iid with 0 mean and st.dev. 
Then,the distance to default DDN over time horizon tN
turns out to be

N
DD N 
s i  d 0 RN   N d K 1  g   d 0
i 1

N

N
2

 i
i 1
with g the average rate of growth of GDP and i  i 1  g 
i
31
An example of Eurobonds
• Financial features of Eurobonds:
– 10 year maturity
– 40% of GDP (d0 = dk)
– Issued at par, with ASW = 0
• Possible credit enhancement features
– Cash guarantee (e.g. 80 billion to ESM)
– Primary surplus limit (e.g. stability pact)
32
Engineering Eurobonds
• Assume a 3% average growth of nominal GDP over next
10 years. Average Europe primary surplus before the
crisis was 1.25% with volatility equal 1.23% (average
volatility is 1.52%, with primary surplus correlation 81%).
• Given these data the distance to default would be 2.445,
and the probability of primary surplus paths insufficient to
cover Eurobonds interest expenses would be 0.7417%.
• Under these assumptions buying protection on a CDS
would cost 5 192 € for 10 000 000 €. Adding credit
enhancements would reduce this to zero.
33
Credit enhancements
• Cash guarantee: assuming the primary surplus
data will be in line with history, and assuming an
extreme scenario of 0 recovery rate, we compute
a value of less than 24 billions (3300 billions of
nominal times 0.7234%).
• Primary surplus limits: cash guarantee can fail if
average future surplus will be different from the
historical value (a sort of structural break or Peso
problem). However, since the stability pact sets a
limit to budget deficit, we could conceive a lower
limit to primary surplus to a level of 1.25%.
34
Eurobonds effects: Spain
• Assume the Eurobonds in the example are issued
to substitute 40% of Spanish debt.
• In March, the ASW on Spanish debt was equal to
1.77%. Given our model, we computed an implied
value of expected primary surplus of 0.72%.
• Given this same primary surplus, if Spain were to
tranche 40% of its debt, it would pay 0.363% on
senior debt. The impact on the junior debt (which
for Spain represents 20% of GDP) turns out to be
4.55%.
35
Eurobonds effects: Italy
• Assume the Eurobonds in the example are issued
to substitute 40% of Italian debt.
• In February, the ASW on Italian debt was equal to
1.15%. Given our model, we computed an implied
value of expected primary surplus of 1.34%.
• Given this same primary surplus, if Italy were to
tranche 40% of its debt, it would pay 2 bp on
senior debt (that is less than Eurobonds). The
impact on the junior debt (which for Italy
represents 80% of GDP) would turn out 1.73%.
36
Policy conclusions
• Eurobonds are only a financial instrument that
could be used to supply a road map for the
solution of the European debt crisis
• The road map would need consistent planning
and implementation of sustainable fiscal policies
(how to achieve primary surplus, what has to be
public or private)
• Eurobonds would call for renewal of the politics of
financial integration. It could be the spur of a new
integration path heading towards fiscal policy
integration.
37