SOVEREIGNS AND MUNICIPALS: NONCORPORATE ISSUERS

Finally, let's discuss modeling default risk from government issuers. While corporate credit modeling is primarily predicated on measuring a borrower's ability to pay, the key variable in most government credit analysis is measuring a government's willingness to pay back its creditors. Quantitative analysts do not have a particularly enviable record of predicting and modeling sovereign risk. The default by Russia in 1998 was widely considered the catalyst for the collapse of Long Term Capital Management (LTCM), one of the most prominent quantitative hedge funds of that decade. The fund included Myron Scholes and Robert Merton (of Black-Scholes fame) on its board.

The primary distinction that is usually made for these types of issuers is whether the issuer has, or is supported by an actor that has, the power to print the currency that they are borrowing in. Sovereigns that borrow in their national currency (the United States, England, and Japan, for example) are considered very unlikely to actually default, as they have the ability to print money to meet their obligations. Sovereigns that do not have the ability to print the currencies that their debt is denominated in (countries in the Euro area and smaller countries that issue in U.S. dollars such as Grenada or Ecuador) are at much higher risk of default, and in some ways their situation is more akin to a state or city than it is to larger issuers.

While there have been attempts to apply the structural model to sovereign debt, reduced form models are used much more frequently. As with corporate borrows, the likelihood of default and the loss given default both need to be estimated. According to data published by Moody's, over the 25 years between 1983 and 2007, the issuer-weighted recovery rates on defaulted sovereign bonds has averaged 54 percent. However, there has been considerable variability, with observed recoveries ranging from 18 percent to 95 percent of the par value of the bonds. Standard and Poor's publishes recovery ratings that are based roughly on a structural debt concept and the assumption that post-default, the value of the restructured debt will put the country's debt/GDP ratio (and other ratios) in line with solvent peers.

Subnational municipal debt offers similar problems, but with added questions of disclosure. Smaller issuers often fall behind on providing information to investors. As of 2011, there were a number of questions about the solvency of cities and states in the United States, and additional research on the risks to investors in this market is being produced.