Default is easier when you have practice

April 6, 2009

OneEyedMan, in the comments, makes a good point about the cost of default:

If you have less outstanding debt, even after a bankruptcy discharges it, then you are immediately less likely to default. However, in comparison with another firm that doesn’t default, if at some future date you have the same financials, expect the debt markets to charge you more to borrow money. That’s how the UK was able to beat up France time and again. By not defaulting on their debt they had lower borrow costs so they borrowed more. Borrowing more funded bigger wars.

This is a very good encapsulation of one of the big theses of James Macdonald’s excellent book A Free Nation Deep in Debt: The Financial Roots of Democracy. And it has an interesting implication about the cost of default: it’s much higher for entities which have never defaulted before than it is for those who have defaulted in the past. Or, to put it another way, the cost of a second default is a lot lower than the cost of a first default, and the cost of a third default is lower still.

Maybe this means that in times of global upheaval, like today, it makes sense to look to countries like Colombia if you want to minimize credit risk. And indeed, Colombia is trading at a spread of 445bp over Treasuries, which is pretty good, these days: Hungary is at 567bp over, for instance, despite being a member of the EU.

On the other hand, Peru has not only defaulted in the relatively recent past, but even did so under its current president, Alan Garcia. And it’s trading at an enviable 393bp over. So clearly the stigma of having defaulted can be overcome.

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