Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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

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.

Historical Documents, 1660-1714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

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

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

… 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

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

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

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
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.


2 responses to “More on Sovereign Defaults

  1. bigalwp March 16, 2009 at 12:10 am

    This is great summary – I would just point out the issue with sourcing sovereign risk in form of CLNs. First, it’s not like you call up Joe the retail Belgian investor and say Hi there my bank needs to buy protection on US CDS – can I sell you a $100mm CLN linked to US risk which after the margin I need to make on the trade (1-3%) actually yields less than treasuries while exposing you to my banks counterparty risk? There are 3 problems with the CLN theory: first the size that retail investors do is so small as to largely be negligible, you cant source risk from them whenever you want, normally for all CLN origination the desks hedge themselves in the plain CDS market so they are not running unhedged risks. So at the end of the day somebody somewhere is trading US CDS if there is a CLN being issued.

    • Jayanth Varma March 16, 2009 at 10:34 am

      Thanks a lot for clarifying the nature of retail CLNs. I agree with most of what you say. I think of CLNs as an extreme example of the use of collateral to mitigate counter party risk in an manner which makes it possible for entities to sell default protection on entities more creditworthy than themselves.

      I also agree with your blog post that speculation in the CDS market is not so much about default as about spread widening or narrowing. I would only add that this is/was true of the cash bond market as well. People sold or shorted bonds because they expected a rating downgrade or spread widening rather than outright default over their investment horizon.

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