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Toward a Bottom-Up Approach to Assessing Sovereign Default Risk: An Update

Journal 34: Cass-Capco Institute Paper Series on Risk

Edward I. Altman, Herbert Rijken

We propose a totally new approach toward assessing sovereign risk by examining rigorously the health and aggregate default risk of a nation’s private corporate sector. Models such as our new Z-Metrics™ approach can be utilized to measure the median probability of default of the non-financial sector cumulatively for five years, both as an absolute measure of corporate risk vulnerability and a relative mea-sure compared to other sovereigns and to the market’s assessment via the now liquid credit-default-swap market.

Specifically, we measure the default probabilities of listed corporate entities in 11 European countries and the U.S., as of 2008-2010. These periods coincide with the significant rise in concern with sovereign default risk in the euro country sphere. We conclude that our corporate health index of the private sector measured at periods prior to the explicit recognition by most credit professionals not only gave an effective early warning indicator, but provided a mostly appropriate hierarchy of relative sovereign risk. Policy officials should, we believe, nurture, not penalize, the tax revenue paying and jobs generating private sector when considering austerity measures of distressed sovereigns.

During the past four years, bank executives, government officials, and many others have been sharply criticized for failing to anticipate the global financial crisis. The speed and depth of the market declines shocked the public. And no one seemed more surprised than the credit rating agencies that assess the default risk of sovereign governments as well as corporate issuers operating within their borders.

Although the developed world had suffered numerous recessions in the past 150 years, this most recent international crisis raised grave doubts about the ability of major banks and even sovereign governments to honor their obligations. Several large financial institutions in the U.S. and Europe required massive state assistance to remain solvent, and venerable financial institutions like Lehman Brothers even went bankrupt. The cost to the U.S. and other sovereign governments of rescuing financial institutions believed to pose “systemic” risk was so great as to result in a dramatic increase in their own borrowings.

The general public in the U.S. and Europe found these events particularly troubling because they had assumed that elected officials and regulators were well-informed about financial risks and capable of limiting serious threats to their investments, savings, and pensions. High-ranking officials, central bankers, financial regulators, ratings agencies, and senior bank executives all seemed to fail to sense the looming financial danger.

This failure seemed even more puzzling because it occurred years after the widespread adoption of advanced risk management tools. Banks and portfolio managers had long been using quantitative risk management tools such as Value at Risk (VaR), and should have also benefited from the additional information about credit risk made publicly available by the new market for credit default swaps (CDS).

But, as financial market observers have pointed out, VaR calculations are no more reliable than the assumptions underlying them. Although such assumptions tend to be informed by statistical histories, critical variables such as price volatilities and correlations are far from constant and thus difficult to capture in a model. The market prices of options – or of CDS contracts, which have options “embedded” within them – can provide useful market estimates of volatility and risk. And economists have found that CDS prices on certain kinds of debt securities increase substantially before financial crises become full-blown. But because there is so little time between the sharp increase in CDS prices and the subsequent crisis, policymakers and financial managers typically have little opportunity to change course.

The most popular tools for assessing sovereign risk are effectively forms of “top-down” analyses. For example, in evaluating particular sovereigns, most academic and professional analysts use macroeconomic indicators such as GDP growth, national debt-to-GDP ratios, and trade and budget deficits as gauges of a country’s economic strength and well-being. But, as the recent euro debt crisis has made clear, such “macro” approaches, while useful in some settings and circumstances, have clear limitations.

In this paper, we present a totally new method for assessing sovereign risk, a type of “bottom-up” approach that focuses on the financial condition and profitability of an economy’s private sector. The assumption underlying this approach is that the fundamental source of national wealth, and of the financial health of sovereigns, is the economic output and productivity of their companies. To the extent we are correct, such an approach could provide financial professionals and policymakers with a more effective means of anticipating financial trouble, thereby enabling them to understand the sources of problems before they become unmanageable.

In the pages that follow, we introduce Z-Metrics™ as a practical and effective tool for estimating sovereign risk. Developed in collaboration with the Risk Metrics Group, now a subsidiary of MSCI, Inc., Z-Metrics is a logical extension of the Altman Z-Score technique that was introduced in 1968 and has since achieved considerable scholarly and commercial success. Of course, no method is infallible, or represents the best fit for all circumstances. But by focusing on the financial health of private enterprises in different countries, our system promises, at the very least, to provide a valuable complement to, or reality check on, standard “macro” approaches.

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