Wednesday, December 08, 2010

Sovereign Debt Is Never Risk-Free

Let's get one thing straight.  There is no such thing as risk-free sovereign debt.  The European Union had excluded such debt from banks' capital requirements on the premise that it would never endanger a bank's balance sheet.  Now we all know better. 

Allow me to offer the EU a way out of its quandry on how to weight sovereign debt.  Skip the reliance on rating agencies.  Calculate a simple weighted formula for a given nation's bonds covering its entire existence as a sovereign state, then weight a zero value for any years in which that nation's debt was in arrears.  Let's say Country X has been independent for 100 years.  If it defaulted in 1933 and recovered in 1936, that's four calendar years weighted as zero.  The country's bonds thus have an expected value of 96% of their face value. 

My simplistic approach lacks the sophistication of the complex models built by PhDs at credit rating agencies and investment banks.  Those entities have proven themselves incompetent at assessing risk, so the Alfidi method is a clear improvement.