CHAPTER 13A Bottom‐Up Approach to Assessing Sovereign Default Risk*

In our list of Applications of Distressed Prediction models in Chapter 10 and 11, for example, Figure 11.1, we noted extending micro‐oriented corporate models to the sovereign risk arena. This chapter now goes into greater depth on that theme. In the past decade, bank executives, government officials, and many others have been sharply criticized for failing to anticipate the global financial crisis. The speed and depth of the market declines shocked the public. And no one seemed more surprised than the credit rating agencies that assess the default risk of sovereign governments, as well as corporate issuers operating within their borders.

Although the developed world had suffered numerous recessions in the past 150 years, this most recent international crisis in the wake of the mortgage‐backed security downfall in 2008–2009, raised grave doubts about the ability of major banks and even sovereign governments to honor their obligations. Several large financial institutions in the United States and Europe required massive state assistance to remain solvent, and venerable banks like Lehman Brothers even went bankrupt. The cost to the United States and other sovereign governments of rescuing financial institutions believed to pose “systemic” risk was so great as to result in a dramatic increase in their own borrowings. The general public in the United States and Europe found these events particularly troubling because ...

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