Monday, May 9, 2011

Will Michigan and Illinois Default?

Two professors, Andrew Ang and Francis A. Longstaff, are out with a paper on the likelihood of systemic risk among the PIIGS versus several U.S. states. The paper uses a lot of econometric modeling that I disagree with. When will econometricians learn that there are no constants in the world of economics and so modeling can not be done in the quantitative manner that they attempt?

If these guys really think that the systemic risk for Illinois to go bankrupt is zero, as they say in their paper, if California files for bankruptcy, then I really want to sell them my new fog making machine. I have it up in San Francisco and they can come up and see it any summer.

Earth to Ang and Longstaff, if California goes down, Illinois is unlikely to get enough financing through the markets to buy a pre-packaged ham sandwich.

The most interesting part of the Ang-Longstaff paper is a bit of history they provide on state bankruptcies in the US:
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.
Also of note, though the mathematical preciseness of their presentation is questionable, Ang-Longstaff display a chart showing the recent likelihood of default of Michigan and Illinois versus Greece and Portugal.

The mathematical mumbo jumbo they use to reach this phony precise probability of default (They really need to read Mises on case versus class probability) is not as interesting as the fact that they acknowledge that Michigan and Illinois could default.

When mainstream economists (Ang is a professor at Columbia Business School. Longstaff is a professor at UCLA-Anderson School of Management)  are talking about the probability of the default of states (though using faulty methodology), you know the financial and economic situation is very fragile.

Mainstream economists generally don't discuss such topics unless the situation is quite obvious. In other words, unless there is a Federal rescue, it looks like we are getting to the stage where it becomes clear to all that some states will eventually default.


  1. Our take on the possibilities of a default in California. Keeping in mind that the state's constitution calls for bondholders to get paid before everyone except schools, a default is about as likely as the state gutting all other obligations to keep making those payments.

    So yes, a California default would mean an ugly, ugly state of affairs, and states like Illinois likely wouldn't stand a chance after that.

  2. I'm not smart enough to play forecaster but I found this connection to be interesting with regards to the prospects for QE-X and beyond. A peak in the default probability for Michigan right around the start of the "bull market" in 2009.

    "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...

    ..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.

    My question is, what happens to the US credit rating if a state defaults? Does the "flight to safety" rationale still hold or does everyone head for the exits? We may find out soon.

  3. I agree with GSL's link that most locals will pay their debt obligations while cutting everything else. However, once the pension timebombs go off (starting in 2018-or earlier if we have a market collapse), then you'll see defaults across the board.

  4. That article is very scientistic indeed. Although short, reading it was almost unbearable. This is the kind of vapid piece written to try to impress gullible people (I suspect students and faculty) of how smart they are.

    The end result is an attempt to assuage those who may be losing faith in big government spending. Look, don't worry about big-government Illinois with a population of 12 million and a deficit of $13 billion. It's less likely to default than Florida with a population of nearly 20 million, deficit of $2 billion or less and a serious budget cutting/deregulating governor.