by Calculated Risk on 8/02/2010 08:15:00 PM

A few excerpts from Professor Krugman: Why Is Deflation Bad?

There are actually three different reasons to worry about deflation, two on the demand side and one on the supply side.

So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. ....

A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. ...

Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. ...

Now, alert readers will have noticed that none of these arguments abruptly kicks in when the inflation rate goes from +0.1% to -0.1%. Even with low but positive inflation the zero lower bound may be binding; inflation that comes in lower than borrowers expected leaves them with a worse debt burden than they were counting on, even if the inflation is positive; and since relative wages are shifting around all the time, some nominal wages will have to fall even if the overall rate of inflation is a bit above zero.

There are more details at Krugman's post.

The third point on sticky wages (and prices) is very important. Relative wages are being adjusted all the time in the economy. With some inflation, real wages can be cut (if needed) by keeping wage increases below the inflation rate. However, if inflation is near zero - or there is deflation - many companies that need to cut wages a little will have difficulty competing since it is difficult to cut nominal wages. This is a key reason why a little inflation is better than no inflation. Of course too much inflation is really bad too, but that isn't the problem right now.

by Calculated Risk on 8/02/2010 05:04:00 PM

1) July Auto Sales. Light vehicle sales will be reported tomorrow by the automakers. In the weekly schedule, I noted that "expectations are for about a 11.6 million SAAR for light vehicles in July – up from the 11.1 million sales rate in June." There is a pretty wide range in forecasts:

From Bloomberg: Auto Sales May Rise to Highest of Year on U.S. Closeout Deals

Industrywide deliveries ... may reach an annualized rate of 11.9 million vehicles in July, the average of eight analysts’ estimates compiled by Bloomberg. That would be 5.3 percent higher than last year’s 11.3 million pace and the best month since August 2009 ...

And from Reuters: Auto Sales in US Expected to Rise Slightly in July

Analysts surveyed by Reuters expected an average annualized sales rate of 11.4 million vehicles in July, up slightly from 11.1 million in June and 11.2 million a year earlier. Forecasts for July range from 11.1 million to 12.1 million vehicles.

2) Pending Home Sales: The consensus is for a slight decline in the pending homes sales index for June, after the 30% drop decline in May. Lawler expects about a 3% decline (based on limited data).

3) FOMC meeting on August 10th: There has been some speculation that the FOMC would ease monetary policy next week. As an example from CNBC: Fed Will Ease Monetary Policy on Aug. 10: Economist

Japan's Nomura has become the first investment bank to predict the Federal Reserve will begin to ease monetary policy following the recent slowdown in growth in the world's biggest economy.

The deterioration in expectations for growth and inflation argues for an easing of monetary policy, Paul Sheard, the global chief economist at Nomura, wrote in his latest report.

Given Chairman Bernanke's comments this morning, this seems very unlikely. Bernanke's speech was fairly positive, and I think the FOMC statement might note that growth has slowed, but the "extended period" wording will probably remain the same - and there will probably be no mention of further easing. The following was the key sentence in Bernanke's speech:

"In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions."

Unless there is a huge downside surprise this week, I think the FOMC statement will basically remain the same.

by Calculated Risk on 8/02/2010 02:54:00 PM

Usually when auction buyers lose money it is because they either overvalue the home, or the home was seriously damaged. However this is an unusual story from Carolyn Said at the San Francisco Chronicle: Winning bid on mortgage buys family heartache (ht Jesse)

Roberta and Randall Strand took $97,606 out of their paid-off house to buy a foreclosed home at a courthouse auction. Five months later, they found out they actually bought the second mortgage, and that the bank planned to foreclose on the first mortgage, leaving them out in the cold.

This is pretty easy to check. In this case the lender (Wachovia, now Wells Fargo) held both the 1st and 2nd and foreclosed on both. Because of timing issues, the 2nd went to the court house steps first - and the buyers are now out around $100,000. Well, probably less ...

Wells and the family negotiated a confidential settlement and were finalizing details late last week.

by Calculated Risk on 8/02/2010 12:06:00 PM

Overall construction spending increased slightly in June, and private construction spending, both residential and non-residential, decreased in June.

Click on graph for larger image in new window.

This graph shows private residential and nonresidential construction spending since 1993. Note: nominal dollars, not inflation adjusted.

Residential spending is now 62% below the peak of early 2006.

Private non-residential construction was revised down for both April and May, and spending is now 35% below the peak of late 2008.

From the Census Bureau: June 2010 Construction at $836.0 Billion Annual Rate

The U.S. Census Bureau of the Department of Commerce announced today that construction spending during June 2010 was estimated at a seasonally adjusted annual rate of $836.0 billion, 0.1 percent (±1.6%)* above the revised May estimate of $834.8 billion.
...
Spending on private construction was at a seasonally adjusted annual rate of $527.6 billion, 0.6 percent (±1.3%)* below the revised May estimate of $530.9 billion. Residential construction was at a seasonally adjusted annual rate of $258.3 billion in June, 0.8 percent (±1.3%)* below the revised May estimate of $260.3 billion. Nonresidential construction was at a seasonally adjusted annual rate of $269.3 billion in June, 0.5 percent (±1.3%)* below the revised May estimate of $270.6 billion.

I expect:

Private residential construction spending will decline sharply in July since builders rushed to complete homes in June (because of the tax credit).

Private non-residential investment in structures will be revised down in the Q2 GDP report. The advance GDP report showed an increase in non-residential investment in structures of 5.2% (SAAR) and a positive contribution to GDP of 0.14 percentage points. This will probably be revised away.

Based on the Architecture Billings Index, non-residential spending will decline further in 2010 - and into 2011.

Residential spending will probably exceed non-residential later this year (or early 2011), but that will be mostly because of weakness in non-residential construction, as opposed to any significant increases in residential spending.

by Calculated Risk on 8/02/2010 10:18:00 AM

From Fed Chairman Ben Bernanke: Challenges for the Economy and State Governments

On the economy:

While the support to economic activity from stimulative fiscal policies and firms' restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth. In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment. At the same time, rising U.S. exports, reflecting the expansion of the global economy and the recovery of world trade, have helped foster growth in the U.S. manufacturing sector.

To be sure, notable restraints on the recovery persist. The housing market has remained weak, with the overhang of vacant or foreclosed houses weighing on home prices and new construction. Similarly, poor economic fundamentals and tight credit are holding back investment in nonresidential structures, such as office buildings, hotels, and shopping malls.

Importantly, the slow recovery in the labor market and the attendant uncertainty about job prospects are weighing on household confidence and spending. After two years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, an improvement but still a pace insufficient to reduce the unemployment rate materially. In all likelihood, significant time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than six months.

On state and local governments:

Cuts in state and local programs and employment are also weighing on economic activity. These cuts principally reflect the historically large decreases in state tax revenues during the recession. Sales tax revenues have declined with household and business spending, and income tax revenues have been hit by drops in wages and salaries, capital gains, and corporate profits. In contrast, property tax revenues collected by local governments generally held up well through the beginning of this year, although reappraisals of the values of homes and commercial properties may affect those collections in the future.
...
With revenues down and Medicaid spending up, other categories of spending by state governments have been tightly squeezed. Over the past year, numerous state governments have laid off or furloughed employees, decreased capital spending, and reduced aid to local governments. Indeed, state and local payrolls have fallen by more than 200,000 jobs from their peak near the end of 2008. Some states have also raised taxes, but the weak economy has made it difficult to find significant new revenues.

Assistance from the federal government, especially through the fiscal stimulus package, has eased, but certainly not eliminated, the budget difficulties faced by states. Although states and localities will continue to receive significant aid this year, that source of help will be winding down next year.

On a more positive note, state and local tax revenues seem set to increase as economic activity expands.

This is a fairly positive outlook for the overall economy, but less so for local governments.

by Calculated Risk on 8/02/2010 10:00:00 AM

PMI at 55.5% in July down from 56.2% in June.

From the Institute for Supply Management: July 2010 Manufacturing ISM Report On Business®

Economic activity in the manufacturing sector expanded in July for the 12th consecutive month, and the overall economy grew for the 15th consecutive month, say the nation's supply executives in the latest Manufacturing ISM Report On Business®.

The report was issued today by Norbert J. Ore, CPSM, C.P.M., chair of the Institute for Supply Management™ Manufacturing Business Survey Committee. "Manufacturing continued to grow during July, but at a slightly slower rate than in June. Employment, supplier deliveries and inventories improved during the month and reduced the impact of a month-over-month deceleration in new orders and production. July marks 12 consecutive months of growth in manufacturing, and indications are that demand is still quite strong in 10 of 18 industries. The prices that manufacturers paid for their inputs were slightly higher but stable, with only a few items on the short supply list."
...
ISM's New Orders Index registered 53.5 percent in July, which is a decrease of 5 percentage points when compared to the 58.5 percent reported in June.
...
ISM's Employment Index registered 58.6 percent in July, which is 0.8 percentage point higher than the 57.8 percent reported in June. This is the eighth consecutive month of growth in manufacturing employment.
emphasis added

by Calculated Risk on 8/01/2010 08:52:00 PM

From David Barboza at the NY Times: State-Owned Groups Fuel China’s Real Estate Boom

All around the nation, giant state-owned oil, chemical, military, telecom and highway groups are bidding up prices on sprawling plots of land for big real estate projects unrelated to their core businesses.
...
By driving up property prices, the state-owned companies, which are ultimately controlled by the national government, are working at cross-purposes with the central government’s effort to keep China’s real estate boom from becoming a debt-driven speculative bubble ...

The story mentions a salt company building luxury high rises ... that seems very speculative!

A repeat: Early this morning Part 5C of the Sovereign Default series: Some Policy Options, Good and Bad

Yesterday: Negative Equity Breakdown. The authors estimate there are 4.1 million homeowners with more than 50% negative equity, and another 5 million with 20% to 50% negative equity.

And How do you put recession bars on graphs using Excel?

by Calculated Risk on 8/01/2010 02:55:00 PM

The previous post was the weekly schedule (busy week ahead!) and summary of last week (scroll down for post).

Early this morning Part 5C of the Sovereign Default series: Some Policy Options, Good and Bad

From the WSJ: Chinese Manufacturing Growth Slows

China's manufacturing activity expanded at the slowest pace in 17 months in July ... China's official PMI ... fell to 51.2 in July from 52.1 in June, the third straight month in which it has declined. The reading was also closer to the expansionary threshold of 50 than it had been in 17 months. A reading below 50 signals contraction.

Yesterday:

Negative Equity Breakdown. The authors estimate there are 4.1 million homeowners with more than 50% negative equity, and another 5 million with 20% to 50% negative equity.

How do you put recession bars on graphs using Excel?

by Calculated Risk on 8/01/2010 11:55:00 AM

The key economic report this week will be the July Employment Report to be released on Friday. It will be a busy week ...

On Monday, the Census Bureau will release Construction Spending for June at 10 AM. The consensus is for a 0.5% decline in spending (although the tax credit related decline will show up in the July report). Also on Monday, the ISM manufacturing survey for July will be released at 10 AM ET. Most of the regional surveys suggest growth in the manufacturing sector slowed in July, and the consensus is for a decline in the ISM index to 54 from 56.2 in June.

Also on Monday, Fed Chairman Ben Bernanke will address the Southern Legislative Conference 64th Annual Meeting at 10:30 AM ET in Charleston, South Carolina. The title of his speech is: "Challenges for the Economy and State Governments"

On Tuesday, the BEA will release the June Personal Income and Outlays report. The consensus is for a 0.1% increase in income, and a 0.1% increase in spending. With the strong downwards revision in the GDP report for personal consumption expenditures, this report will be interesting (the savings rate increased too).

Also on Tuesday, the June Manufacturers' Shipments, Inventories and Order will be released at 10 AM, and the NAR will release Pending Home Sales for June. The collapse for pending home sales happened in May, and this report might show another slight decline.

Also on Tuesday, the automakers will report vehicle sales for July. Expectations are for about a 11.6 million SAAR for light vehicles in July – up from the 11.1 million sales rate in June. Some forecasts are even higher, from Edmunds:

Edmunds.com analysts predict that July's Seasonally Adjusted Annualized Rate (SAAR) will be 11.8 million, up from 11.1 in June 2010.

"July sales numbers should be the highest we've seen since last August's 'Cash for Clunkers' frenzy," reported Edmunds.com Senior Analyst Ray Zhou, PhD. "Retail demand for new cars this month has been the strongest of the year, even more than in March when Toyota launched an aggressive incentive campaign and other automakers followed suit."

Also on Tuesday, the American Bankruptcy Institute will probably report personal bankruptcy filings for July. This will probably show another "surge" in filings.

On Wednesday, the ADP employment report will be released (consensus is for an increase of 35K private sector jobs, up from 13K in June). Also on Wednesday, the ISM non-manufacturing index for July will be released at 10 AM. The consensus is for a slight decline from the 53.8 June reading. Also on Wednesday, the MBA will release the mortgage Purchase Applications Index. This index collapsed following the tax credit, but has been bouncing around at a low level for the last couple of months.

Also on Wednesday, the quarterly NMHC Apartment Market Tightness index for July will probably be released. Last quarter this report showed a surprising tightening in the apartment market index, and some increases in effective rents.

On Thursday, the initial weekly unemployment claims report will be released. Consensus is for a slight decline to 455K from 457K last week.

And on Friday, the BLS will release the July Employment report at 8:30 AM. The consensus is for a loss of 70,000 payroll jobs in July, and for the unemployment rate to increase slightly to 9.6% (from 9.5%). Of course the minus 70,000 includes a substantial decline in the number of temporary hires for Census 2010 (May was the peak month). It will be important to remove the Census hiring to try to determine the underlying trend. Consensus is around a gain of 75,000 payroll jobs ex-Census. (see Estimate of July Decennial Census impact on payroll employment: minus 144,000 ).
As a reminder, the media stories on the employment report will be confusing because of the Census hiring. There are three numbers that will be reported:

The headline number: consensus is for minus 70,000 jobs lost.

The headline number minus temporary Census workers (ex-Census): consensus is for around 75,000 payroll jobs added, and

Private sector hiring only. Consensus is for 100,000 jobs added.

All three numbers have meaning, but when trying to remove the impact of hiring for the decennial Census, the 2nd number is consistent with non-Census year reports.

Also on Friday the Fed will release Consumer Credit. The consensus is for another decline in credit of around $5 billion. And Friday afternoon will be another BFF (Bank Failure Friday) ...

And a summary of last week:

New Home Sales: Worst June on Record

The Census Bureau reported New Home Sales in June were at a seasonally adjusted annual rate (SAAR) of 330 thousand. This is an increase from the record low of 267 thousand in May (revised from 300 thousand). Ignore all the month to previous month comparisons. May was revised down sharply and that makes the increase look significant. Here is the bottom line: this was the worst June for new home sales on record.

Click on graph for larger image in new window.

This graph shows monthly new home sales (NSA - Not Seasonally Adjusted).

Note the Red columns for 2010. In June 2010, 30 thousand new homes were sold (NSA). This is a new record low for June.

The previous record low for the month of June was 34 thousand in 1982; the record high was 115 thousand in June 2005.

Here are more graphs based on the New Home sales report.

Q2: Real annualized GDP 2.4%, mostly downward revisions to prior quarters

Special Note: I apologize for a couple of errors in my original GDP post. I make plenty of typos, but I usually get the math right. I corrected the error as soon as possible.

From the BEA:

Real gross domestic product ... increased at an annual rate of 2.4 percent in the second quarter of 2010 ... Real personal consumption expenditures increased 1.6 percent in the second quarter, compared with an increase of 1.9 percent in the first.

Here is a summary of the revisions to prior years:

Quarter	GDP before revisions	Current GDP estimate	Change
2007-I	1.2%	0.9%	-0.3%
2007-II	3.2%	3.2%	0.0%
2007-III	3.6%	2.3%	-1.3%
2007-IV	2.1%	2.9%	0.8%
2008-I	-0.7%	-0.7%	0.0%
2008-II	1.5%	0.6%	-0.9%
2008-III	-2.7%	-4.0%	-1.3%
2008-IV	-5.4%	-6.8%	-1.4%
2009-I	-6.4%	-4.9%	1.5%
2009-II	-0.7%	-0.7%	0.0%
2009-III	2.2%	1.6%	-0.6%
2009-IV	5.6%	5.0%	-0.6%
2010-I	2.7%	3.7%	1.0%
2010-II		2.4%

The revisions indicate that the recession was worse than originally estimated, and the recovery slightly weaker.

Here is a graph of the real PCE revisions.

Annualized real PCE is now 0.85% below the pre-recession peak.

This was a substantial downward revision.

Case-Shiller: House Price indexes increase in May

S&P/Case-Shiller released the monthly Home Price Indices for May (actually a 3 month average).

This graph shows the nominal seasonally adjusted Composite 10 and Composite 20 indices (the Composite 20 was started in January 2000).

The Composite 10 index is off 29.3% from the peak, and up 1.0% in May (SA).

The Composite 20 index is off 28.7% from the peak, and up 1.1% in May (SA).

The next graph shows the price declines from the peak for each city included in S&P/Case-Shiller indices.

Prices increased (SA) in 15 of the 20 Case-Shiller cities in May seasonally adjusted.

Prices in Las Vegas are off 56.1% from the peak, and prices in Dallas only off 4.8% from the peak.

Note: Prices are probably starting to fall right now, but this will not show up in the Case-Shiller index for a few months.

Q2 2010: Homeownership Rate Lowest Since 1999

The Census Bureau reported the homeownership and vacancy rates for Q2 2010 this week.

The homeownership rate declined to 66.9%. This is the lowest level since 1999.

Note: graph starts at 60% to better show the change.

The homeownership rate increased in the '90s and early '00s because of changes in demographics and "innovations" in mortgage lending. The increase due to demographics (older population) will probably stick, so I've been expecting the rate to decline to the 66% to 67% range - and not all the way back to 64% to 65%.

For more on the homeownership rate, see: How far will the homeownership rate fall?

Here are graphs of the homeowner and rental vacancy rate.

Other Economic Stories ...

From Sewell Chan at the NY Times: In Study, 2 Economists Say Intervention Helped Avert a 2nd Depression. Here is the paper: How the Great Recession Was Brought to an End

From the Chicago Fed: Index shows economic activity declined in June

From the Census Bureau: Durable Goods orders fall 1% in June

From the Federal Reserve: Beige book

Economic activity has continued to increase, on balance, since the previous survey, although the Cleveland and Kansas City Districts reported that the level of economic activity generally held steady.

From the American Trucking Association: ATA Truck Tonnage Index Fell 1.4 Percent in June

From the Dallas Fed: Texas Manufacturing Activity Remains Sluggish

From the Richmond Fed: Manufacturing Activity Moderates in July; Expectations Slip

From the Kansas City Fed: Tenth District manufacturing activity rebounded moderately in July

From the Institute for Supply Management – Chicago: Chicago PMI shows expansion in July

From the National Restaurant Association (NRA): Industry Outlook Softened in June as the Restaurant Performance Index Declined for the Third Consecutive Month

Unofficial Problem Bank List over 800 Institutions

Best wishes to all.

by Calculated Risk on 8/01/2010 07:13:00 AM

CR Note: This series is from reader "some investor guy".

Financial institutions, governments, and central banks can be creative in a crisis. Policy options fall into three broad groups: options for deeply distressed or defaulted sovereigns; options for creditors; and regulatory policies. In this part, we discuss the first two. Regulatory options will come in a later part.

To some extent, we’ve seen something similar to the Really Bad sovereign default situation before in the 2008 crisis. There have also been several episodes of very bad sovereign default over the past 200 years.

In our Really Bad scenario, about half of the sovereign debt is in default, and more would be downgraded so that it isn’t useful as collateral in many circumstances. In 2008, central banks from many countries provided cash and guarantees to help with the crisis. What happens when many of those governments and central banks are themselves in trouble? That too has happened before, coincidentally often shortly after banking crises.

Click on graph for larger image in new window.

Source: Banking Crises: An Equal Opportunity Menace, Reinhart and Rogoff.

The authors claim that

“Banking crises dramatically weaken fiscal positions in both groups, with government revenues invariably contracting, and fiscal expenditures often expanding sharply. Three years after a financial crisis central government debt increases, on average, by about 86 percent. Thus the fiscal burden of banking crisis extends far beyond the commonly cited cost of the bailouts.”

Options for Distressed or Defaulted Sovereigns. What will sovereigns do? Some of the more common or reasonable options which are available to sovereigns who are in distress or at high risk of default include:

1. Dialing for Dollars (or Euros, Yen, or other currencies). Just like a college student who is out of money, many countries will call their friends, relatives, and business associates. They will be looking for gifts, subsidies, loans, guarantees, and cosigners. Sometimes, having a big letter of credit and some liquidity buys enough time to actually fix things.

Greece called the EU and the IMF for help. We will probably see more of that from other countries. Many people are surprised to find that usually most of the loan commitments made by the IMF are not drawn upon.

2. The most common option, for those in or near default is to negotiate with creditors. This could involve combinations of reducing principal, extending maturity, and reducing interest rates. For some sovereigns, there might be new debt in a different currency, like Drachma, or Lira instead of Euros. For an interesting and detailed overview of options for Greece, see How to Restructure Greek Debt, by Buchheit and Gulati.

3. Print money to pay debts. Not all countries can do this. Members of the euro can’t unilaterally print money. Greece can’t just print its own money. Japan can. A large number of countries can print their own money, but most of their debt is in dollars or euros. For example, many eastern European countries can print, but have debts in euros.

If they print, they have to convert that money to another currency. Historically, inflation has not generally been a method of preventing defaults, but as often occurred at the same time or shortly afterward. (chart source: This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, Reinhart & Rogoff).

4. Print money, sell assets, or borrow from others to buy back your debts at a large discount. No need to default.

Usually governments try to calm bond market fears to keep their borrowing costs low. However, if many owners of your debt are very worried, are scrambling for cash, or are willing to part with bonds priced at 50 cents on the dollar, it is the author’s opinion that you should strongly consider taking the deal. Those are likely to be medium to long term bonds, and you could cut your debt service substantially for years, or even decades.

Ford did a version of this in 2009 and paid less than half of face value. Here is an overview. Fabulous idea in the right circumstances (even though one of the rating agencies completely missed the point and thought it was equivalent to selective default, they clued in later). The hard part of doing this is usually finding enough cash to buy back debt at a deep discount. Ford had plenty of cash, always a good thing to have in a crisis.

If you happen to be a government with some very marketable assets lying around (e.g., gold, oil, a pile of hard currency in a sovereign wealth fund) and you are not in default, this could work out quite well. Brazil is a country that has successfully done this, and gotten a rating upgrade.

Governments with no distress have also bought back bonds. In 2000, the US Treasury was running a surplus (remember that? Seems so long ago), and bought back billions in 30 year bonds.

5. Austerity. Austerity is often useful for countries in moderate distress, especially if they could balance their budget with debt restructuring. For countries who have already defaulted, austerity is commonly part of emerging from default. Austerity is not useful if lot of money is required quickly. That could easily happen when maturing debt needs to be rolled over, and no one wants to buy it.

It could also happen on interest rate or FX derivatives. In a crisis, swap payments and/or collateral could be rising quickly, and would be due on short time horizons. A few months at the most, and sometimes a few hours.

And there are some slightly edgier options. Some of these might be fully justified in certain circumstances. Others might just be ways of disguising default, seizure, or stupidity.

6. Default only on the foreign debt. It is common for a country to issue multiple types of debt, often with one class of debt mostly owned by residents, and another class mostly owned by foreigners.

Domestic financial interests, voters, and even graffiti taggers often understand the difference, and often put pressure on governments to “stick it to the foreign investors”. Oddly, the opposite often occurs, with domestic debt being devalued along with the domestic currency, and foreign debt remaining in dollars or euros.

Photo source.

7. Seize assets. Why would a debtor seize assets? Three common answers: because they can; because they feel they “have to”; or because they feel they have been wronged. One example is Argentina in 2001, which expropriated $3.1 billion of pension assets in exchange for Treasury notes in Dec 2001, and then defaulted anyway in Jan 2002. This chart shows a timeline of how things went wrong.

8. Claim fraud and try not to pay, especially for OTC derivatives. The possible rationales are endless. An example case from Italy is here. Prosecutor “Robledo alleges the London units of the four banks misled Milan on the economic advantage of a financing package that included the swaps and earned 101 million euros in hidden fees.
He also claims the banks violated U.K. securities rules by failing to inform Milan in writing that for the swap deal the city was a counterparty to the lenders rather than a customer. Banks abiding by the rules of the Financial Services Authority are required to shield customers from conflicts of interest and provide them with clear and fair information that isn’t misleading.” The prosecutor seized assets from the banks equal to their share of the alleged profit.

9. Claim that contracts were invalid in the first place. An example of this is Iceland, “Iceland’s lenders may lose as much as $4.3 billion, equivalent to a third of the economy, after a court last month found that some foreign loans were illegal”. There may also be sovereigns claiming that some official was not authorized to enter into particular loans or derivatives.

10. Claim the people who entered into certain contracts were trying to cause default or distress for the sovereign. Germany made this illegal earlier this year.

11. Depose, subpoena, or even arrest some of the counterparties. A number of countries have rather different legal traditions than the US, the EU, or Japan, and lots of their jails aren’t up to Western standards either. Your typical counterparty doesn’t have these kinds of powers. Once a regulator or prosecutor starts digging, they might find nothing. Or, they might find something extremely damaging. Even charges unrelated to cheating a sovereign could carry some serious jail time, like bid-rigging, money laundering, or tax evasion.

There are also some recent examples of central bankers or bank CEOs being arrested, which might affect whether the sovereigns would honor contracts they entered into (Kosovo Central Banker, Nigerian banks and customers, multibillion forged claims on UAE Central Bank on two separate occasions). Here, here and here.

12. Cut loose sovereign wealth funds, quasi national organizations, and other borrowers or CDS participants which are separate legal entities. Depending on “moral obligations” or “implied guarantees” is always risky. Investors in Fannie Mae and Freddie Mac bonds won their bets that the US government would step in. This will not necessarily be the case elsewhere.

13. And of course, do positive spin, even lie about financial condition. “If a government wants to cheat, it can cheat,” said Garry Schinasi, a veteran of the International Monetary Fund’s capital markets surveillance unit, which monitors vulnerability in global capital markets. Source.

Options for Creditors. For creditors, there are some interesting options. Common ones include:

1. Reduce trade credit, try to get trade sanctions. These are very common measures.

2. Press for higher taxes, business-friendly regulations, austerity. These are straight out of the traditional IMF playbook (now slightly modified).

3. Get your government to bail you out, perhaps by buying defaulted bonds above market price. Another possibility for partial recovery is getting changes to the tax code, such as allowing losses to be carried back, or offset against other forms of income.

4. Seize local assets. There is a long history of this, and sovereigns with extensive foreign assets could be at risk. Recently there was an unsuccessful suit by a creditor to seize assets of Argentina held in the US to compensate for defaulted Argentina bonds.

Somewhat rarer approaches include:

5. Convince your own government to sail gunboats into the harbor of the capital. Sell tickets to the news media. Venezuela in 1913 was a prominent example. Two discussions of how prevalent this method of collection once was or wasn’t are at here and here. This has been rare to nonexistent since World War I. However, looking at the earlier experience, it would be a bad idea to already have major military powers upset at you and default on your bonds. Killing or kidnapping foreign citizens was especially likely to get a response. Having large oil or mineral reserves might also make a country a target.

6. Turn the borrower into part of another country. Yes, there are sometimes sovereign consolidations due to finances. This happens more often at the municipal level, but in the early 1930s Newfoundland went from semi-independent status to being part of Canada. Much of the reason was Canada’s willingness to pay most of Newfoundland’s debt. More details here. While this might occur somewhere at the country level in the Really Bad scenario, it’s more likely to happen with municipalities, provinces, or states.


Disclosures: At a prior job Some Investor Guy had a number of automakers as clients. He owns some Ford bonds, some other corporate bonds, and some municipals. He owns no foreign sovereigns, because he is expecting prices to fall and yields to rise on many of them. He owns no gold, has very little in equities, some real estate, and a lot of cash. Make your own decisions on what your portfolio should be. This is disclosure, not investment advice. Some Investor Guy has no remote doomstead or bomb shelters, but thinks everyone should have a week’s worth of water and food. There are plenty of disasters where those could be useful. He does sometimes talk to regulators and lawmakers.

Next: Part 5D. What if Things Go Really Badly? Banks. This part was moved a bit later to allow more thorough analysis of the European Bank Stress Tests.

CR Note: This series is from "Some investor guy"

Series:
• Part 1: How Large is the Outstanding Value of Sovereign Bonds?

• Part 2. How Often Have Sovereign Countries Defaulted in the Past?

• Part 2B: More on Historic Sovereign Default Research

• Part 3. What are the Market Estimates of the Probabilities of Default?

• Part 4. What are Total Estimated Losses on Sovereign Bonds Due to Default?

• Part 5A. What Happens If Things Go Really Badly? $15 Trillion of Sovereign Debt in Default

• Part 5B. Part 5B. What Happens If Things Go Really Badly? More Things Can Go Badly: Credit Default Swaps, Interest Swaps and Options, Foreign Exchange

• Part 5C. Some Policy Options, Good and Bad

• Part 5D. European Banks, What if Things Go Really Badly?