Sovereign Debt; Back Door Cramdowns

Back Door Cramdowns

Calculated Risk notes that while cramdowns of first mortgages in Chapter 13 bankruptcies are difficult to obtain, that it is possible to reclassify a second mortgage as unsecured debt in Chapter 13 and effectively cram it down (i.e. reduce the collateral post-bankruptcy to its fair market value which is zero) when the value of the property is less than the first mortgage.

This has great practical relevance, coming up in about 20% of Chapter 13 bankruptcies, particularly in areas that have experienced collapsed housing bubbles where many homes had both first and second mortgages. This also suggests that the fair market value of distressed second mortgages may be overstated, as this option is not widely known outside bankruptcy practitioners.

Sovereign Debt

Calculated Risk also has an interesting background series on the risks of default associated with sovereign debt (i.e. government bonds), using near complete compilations of historical data. A very large share of all investments are tied to sovereign debt, and default rates historically are well studied, fairly predictable in the short to medium term, and higher than you might expect.

The odds of a default in the next five years on the United States national debt inferred from investor behavior is about 3.4%. This is very low by international standards, and the size of the U.S. national debt relative to GDP is not particularly high by international standards, but the market based default risk estimate is much higher than the zero risk assumed by economists and analysts for a wide variety of practical purposes.

It is also interesting to note that Japan and the United States combined have half of the world's sovereign debt, and that Japan's sovereign debt is at a considerably higher risk of default than that of the United States. A market based estimate puts the risk of a Japanese debt default over the next five years at 8.3%.