By Andrew Ang and Francis A. Longstaff

US states are a lot like Eurozone nations.

• Investors are concerned about the possibility of state default, especially for states like California, Michigan, and Illinois, just as they are concerned about possible defaults for European periphery countries like Greece, Ireland, and Portugal.
• The largest states pull roughly the same economic punch as the largest European countries.

California’s economy is larger than Spain and approximately 90% the size of Italy. Michigan, despite its recent industrial decline, still has an economy larger than Greece, Portugal, or Ireland taken separately.

• US states are in a dollar currency union, just like Eurozone members are in a euro one.

In addition, there are many economic, legal, and political linkages between states just as there are similar, but weaker, linkages among European countries.

• Reinhart and Rogoff’s (2008, 2009) comprehensive work gives us timely reminders that Eurozone countries like Greece, Spain, Austria, and Greece have defaulted before in the 1930s and 1940s, just as some US states have.

Eight states went bankrupt in the 1830s and 1840s, ten states went bankrupt in the late 1800s, and the last state default was Arkansas in 1933.

The nature of US vs. European default risk can tell us something about the nature of systemic risk. Some authors, like Gorton (1988) and Calomiris and Mason (2003) view systemic risk as arising from common macroeconomic shocks on economic fundamentals. Others, such as Diamond and Dybvig (1983) and Brunnermeier and Pedersen (2009), emphasise the role that financial markets play in creating systemic risk through financial flows, funding, liquidity, and risk premia. If systemic risk arises through integrated, common exposure to macroeconomic fundamentals, then we would expect to see a higher level of systemic risk among US states than among European sovereigns.

In our recent research (Ang and Longstaff 2011), we compare US state and European credit risk using credit default swaps (CDS) contracts. We develop a pricing model where sovereign defaults can be triggered from two sources.

• First, Greece may default because of an event specific to Greece, say a Greek banking crisis, that does not affect other Eurozone countries.
• Second, a shock to other countries propagating to Greece, or a shock affecting the whole Eurozone system, could trigger a Greek default.

Thus, defaults may arise from Eurozone-wide events or from only country-specific sources. Similarly, if the US Treasury defaults, this might cause Illinois to also default (exposure to systemic risk), but Illinois might also default on its own (state-specific or idiosyncratic risk).

US and European systemic risk, i.e. the risk that affects all states or Eurozone countries in each respective case, is approximately the same, as Figure 1 shows.

Figure 1. US and European sovereign credit risk

This Figure, like the one below, plots “Poisson intensities” of default in basis points. The way to interpret this is that it is approximately the probability of defaulting over the next year. So, the peak US intensity in early 2009 corresponds to approximately a 100 basis points = 1% probability of the US defaulting over the next year. Note that in general systemic risk for the US risk has been higher than for Europe, except for very recently. The sample ends in the first week of 2011. The Figure also shows that US and European systemic risks have a high degree of comovement with a correlation of approximately 0.95. Put another way, systemic US and European risk are approximately the same in terms of levels and exhibit similar dynamics over time.

Some US states have high default probabilities, comparable to the European periphery. Figure 2 plots default intensities of Illinois (IL) and Michigan (MI) and Greece (GRE) and Ireland (IRE).

Figure 2. Probability of default: Illinois, Michigan, Greece and Ireland

The probability of default for Michigan reached a high of 800 basis points in early 2009 (approximately a 1 in 12 probability of defaulting over the next year) and was actually well above Greece and Portugal at that time. Greece’s default intensities ramped up in January 2010 with the Greek debt crisis and at the beginning of 2011 were over 1200 basis points (approximately a 1 in 8 probability of default over the next year). Ireland’s default intensity rapidly increased in May 2010 when the market started to realise that Ireland’s initial bailout arrangements were probably insufficient to prevent a default. Ireland’s default probability over the next year is well over 10%. Illinois and Michigan’s default probabilities are about half this level, with probabilities of approximately 5% of defaulting over the next year.

How much of these country or state default probabilities are systemic, that is due to exposure to European-wide or US-wide credit events, and how much is due to country-specific or state-specific risk? Assuming that the credit risk of Germany is 1.0 and the credit risk of the US is 1.0, the ratios of the conditional probabilities of default for the sovereign or state relative to Germany or the US are:

All the US states, with the exception of California, have a systemic index of less than one. The average value of the systemic index over all ten states is 0.72. Several states, such as Illinois, New York, and Ohio have little or no systemic default risk. Defaults of these states are likely to be due only to state-specific events.

In stark contrast, systemic default risk is far more important for countries in the Eurozone. Seven of the European sovereigns have systemic indices in excess of one, implying that their probability of a default given a systemic shock exceeds that of Germany. Greece is particularly exposed to systemic risk with an index of 4.69. The next highest values are for Italy, Portugal, Belgium, and Ireland, with indices of 1.71, 1.67, 1.66, and 1.60, respectively. The average value of the systemic indices across European countries is 1.60. Thus, systemic risk is far more important in determining country default risk in Europe than for US states. In an alternative decomposition, we show that systemic default risk is three times as large a component of default risk in Europe as it is in the US

Put another way, if Greece were to default first, it would cause other countries to default and, at worst, coincide with an entire breakdown of the Eurozone. In contrast, if Illinois were to default, this is likely only to affect Illinois without sending other states into default.

This result – that systemic risk exposure is lower in the US – directly contradicts theories that systemic risk is primarily caused by common macroeconomic fundamentals and close economic integration.

What determines systemic risk? A remarkably large amount of systemic risk (approximately 35-45% of total variation) can be explained by financial market variables. In particular, both the fortunes of the US and Europe are linked closely to stock market performance. Large negative returns in stocks lead to increases in systemic default probabilities. Also for both the US and Europe, higher credit risk for corporations and firms increases systemic credit risk.

For the US, lower swap spreads and higher aggregate volatility (VIX) lead to reductions in US systemic risk. These relations are not seen in Europe. The latter is consistent with the view that US Treasury bonds play a “safe haven” or “reserve investment” role in financial markets. When uncertainty in financial markets increases, the resulting global flight to US bonds reduces the credit risk of the US. Interestingly, the systemic default risk of both the US and Europe are linked to the credit worthiness of China, the largest holder of US Treasury debt. As China’s probability of default increases, so do the probabilities of default of the US and Europe.

Conclusions for policymaking

The lessons of this analysis are interesting and relevant for the current policy debate on the European debt crisis.

• Systemic risk is not driven by close macro integration.

If this were the case, US states would have far higher exposure to systemic credit risk. Instead, systemic exposure is very high for European sovereigns.

• The roots of systemic risk lie in the flows, liquidity, risk premiums, and liquidity shocks of financial markets.

Managing these financial market channels is crucial in keeping systemic default risk low.

References

Ang, Andrew, and Francis A Longstaff (2011), “Systemic Sovereign Credit Risk: Lessons from the US and Europe”, SSRN Working Paper.

Brunnermeier, Markus, and Lasse H Pedersen (2009), “Market Liquidity and Funding Liquidity”, Review of Financial Studies, 22, 2201-2238.

Calomiris, Charles W, and Joseph R Mason (2003), “Fundamentals, Panics, and Bank Distress During the Depression”, American Economic Review, 93:1615-1647.

Diamond, Douglas W, and Philip H Dybvig (1983), “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy, 91:401-419.

Gorton, Gary B (1988), “Banking Panics and Business Cycles”, Oxford Economic Papers, 40:751-781.

Reinhart, Carmen M and Kenneth S Rogoff (2008), “The Forgotten History of Domestic Debt”, NBER Working Paper 13946.

Reinhart, Carmen M and Kenneth S Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.

This article originally appeared at VoxEU. Also see: Depressionary bust in Ireland is echoed in California from 2009.