cds spread to default risk
TRANSCRIPT
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Robert J. Grossman, Managing Director
Macro Credit Research
October 2012
Debt Defaults and SovereignRisk: CDS Spreads as aLeading Indicator
CFA Society Austin / San Antonio
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CDS Spreads as a Leading
IndicatorPredictive Performance DuringThe Crisis
Related Research:
CDS Spreads and Default Risk:A Leading Indicator?
(May 12, 2011)CDS Spreads and Default Risk:Interpreting the Signals(October 12, 2010)
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Why Study CDS Spreads?
Pronounced volatility in CDS spreads during the crisis
Spreads are one of the analytical tools used by Fitchs credit analysts (e.g., identifying outliers)
Source: Fitch Ratings, Fitch Solutions
0
500
1,000
1,5002,000
2,500
3,000
6/07 9/07 12/07 3/08 6/08 9/08 12/08 3/09 6/09 9/09 12/09 3/10 6/10 9/10
Monoline REIT Home Builder
Property-Sensitive Sectors CDS Spreads
(bps)
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CDS Spreads as Risk Indicators
CDS spreads increasingly used for risk analysis
Converting spreads to probabilities of default (PD)
Assume 60% loss severity (i.e., 40% recovery rate)
Annual CDS spread = 120 bps (prior example)
Assumptions underlying this formula:
Fixed (rather than stochastic) recovery rate
Risk-neutrality (i.e., no risk premium beyond compensation for EL)
Probability of Default (1 yr) = CDS spread (annualized) /Loss Severity
2% = 1.20% / 60%
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Mixed Performance in Signaling Eventual Defaults
M Months; T Time of credit event
Source: Fitch Ratings, Fitch Solutions, ISDA
CDS Predictiveness of Credit Events Varies by Sector
0
1,000
2,000
3,000
4,000
5,0006,000
7,000
8,000
Months Prior to Credit Event
Corporates (18 Credit Events)Financial Institutions (6 Credit Events)Monolines (3 Credit Events)
(bp)
1-year PD (T12M)
Monolines: 63.8%
Corporates: 22.9%
Financial Institutions: 3.3%
2-year (Cumulative PD)
Monolines: 21.9%
Corporates: 9.9%
Financial Institutions: 2.6%
1-year PD (T6M)
Monolines: 83.1%
Corporates: 45.5%
Financial Institutions: 8.3%
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(bps)
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200
400
600
800
1,000
1,200
6/07 9/07 12/07 3/08 6/08 9/08 12/08 3/09 6/09 9/09 12/09 3/10 6/10 9/10
REIT Home Builder
REIT and Homebuilders: False Positive?
Source: Fitch Ratings, Fitch Solutions
REIT and Homebuilders CDS Spreads and Implied PDs
First Peak (Homebuilder)
Spread = 385 bps
Implied PD = 6.4%
Rise in implied PD, but no credit events in year following the peak
PD for REITs increased by a multiple of 30xfrom trough to peak
(bps)
Second Peak (REIT)
Spread = 1,154 bps
Implied PD = 19.2%
Second Peak (Homebuilder)
Spread = 481 bps
Implied PD = 8.0%
First Peak (REIT)
Spread = 409 bps
Implied PD = 6.8%
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U.S. Banks & Insurance: Spreads Spiked Despite Support
Source: Fitch Ratings, Fitch Solutions
Extraordinary external support (e.g., government assistance, acquisition)
thus, senior debt obligations continued to perform, despite weakened condition
Financial Services CDS Spreads and Implied PDs
0
100
200
300
400
500
600
6/07 9/07 12/07 3/08 6/08 9/08 12/08 3/09 6/09 9/09 12/09 3/10 6/10 9/10
Banks Insurance(bps)
First Peak (Banks)
Spread = 427 bps
Implied PD = 7.1%
Peak (Insurance)
Spread = 487 bps
Implied PD = 8.1%
Second Peak (Banks)
Spread = 247 bps
Implied PD = 4.1%
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U.S. Broker-Dealers: Coincident, Not Leading?
Note: CDS spreads in text boxes are aggregated for the broker-dealer sector as a whole and calculated as the average of the spreads of the individual entities
Source: Fitch Ratings, Fitch Solutions
As of October 2007, PD for sector was 1.1%...
however, several events of distress over ensuing 12-month period
Highest CDS spread observed during period of study: Morgan Stanley (700 bps in October 2008)
U.S. Broker-Dealer CDS Spreads by Entity
0100200300400500
600700800
Goldman Sachs Group Merrill Lynch & Co., Inc. Lehman Brothers Holdings Inc.
Morgan Stanley Bear Stearns Companies Inc.(bps)
March 2008
CDS spreads = 274 bps
Implied PD = 4.6%
October 2007
CDS spreads = 68 bps
Implied PD = 1.1%
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Similar Signals, Different Outcomes
Note: For background and assumptions on peak cohorts above, please see Fitchs report CDS Spreads and Default Risk: Interpre ting the Signals
Source: Fitch Ratings, Fitch Solutions, ISDA
A priori challenge of interpreting spikes in CDS spreads
Industry spreads of> 1,000 bps not necessarily predictive of default risk
Challenge in Differentiating Elevated Default Risk from False Positives
Sample
Entities in
Sample
CDS Spreads
(bps)
Implied One-
Year PD (%)
Credit Events
in Ensuing
Year (%)
Corporates, One Year Prior to Experiencing Credit Events 18 1,374 22.9 100
U.S. Real Estate Investment Trusts Peak Spreads (December 2008) 29 1,154 19.2 0
Financial Institutions, Three Months Prior to Experiencing Credit Events 6 552 9.2 100
European Insurance Companies Peak Spreads (March 2009) 17 507 8.5 0
U.S. Homebuilders Peak Spreads (November 2008) 8 481 8 0
Financial Institutions, One Year Prior to Experiencing Credit Events 6 199 3.3 100
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Performance as Relative Indicators
M Months; T Time of credit event
Source: Fitch Ratings, Fitch Solutions, ISDA
Identifying Outliers Within High-Yield
0
1,000
2,000
3,000
4,000
5,000
6,000
Months Prior to Credit Event
Corporate Credit Events
High-Yield Index
(bp)
12 Months Prior
Credit Events: 1,375 bpHY Index: 772 bp
Differential: 603 bp
24 Months Prior
Credit Events: 305 bp
HY Index: 307 bp
Differential: (2) bp
Six Months Prior
Credit Events: 2,732 bp
HY Index: 1,018 bp
Differential: 1,714 bp
(bps)
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CDS Spreads as a Leading
Indicator
Where Do We Go From Here?
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Corporate Spreads Tighter Since Crisis Peaks
Relatively strong cash positions and funding liquidity
Declining default rates after Dec 08 peak (Fitch-rated): 2009 (2.6%); 2010 (0.5%); 2011 (0.3%)
Global corporate default rate for H1 2012 (Fitch-rated): 0.33%
Source: Fitch Solutions
Global Corporates CDS Spreads
(bps)
0
100
200
300
400
500
600
Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12
Low (Feb 07)
Spread = 53 bps
PD (5 yr) = 4.4%
Peak (Dec 08)
Spread = 493 bps
PD (5 yr) = 34.9%Current (Sep 12)
Spread = 163 bps
PD (5 yr) = 12.9%
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Bank Spreads Remain Volatile, Well Above Pre-crisis Lows
Possible Drivers: Bail-in / reduced support
Regulatory changes
Eurozone stresses
Source: Fitch Solutions
Global Banks CDS Spreads
(bps)
0
50
100
150200
250
300
350
400
Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12
Peak (Mar 09)
Spread = 335 bps
PD (5 yr) = 25.0%
Current (Sep 12)
Spread = 212 bps
PD (5 yr) = 16%
Low (Dec 06)
Spread = 12 bps
PD (5 yr) = 1.0%
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Banks vs. CorporatesSeveral Crossovers
Corporates widened more than banks during the credit crisis (08 09)
Reversal over the recent pastpotential disintermediation for large corporates?
Source: Fitch Solutions
Global Corporates vs. Banks CDS Spreads
(bps)
0
100
200
300
400
500
600
Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12
Global Corporates Global Banks
Low (5 yr PD)
Corp = 4.4% (Feb 07)
Banks = 1.0% (Dec 06)
Peak (5 yr PD)
Corp = 34.9% (Dec 08)
Banks = 25.0% (Mar 09)
Current (Sep 12) 5 yr PD
Corp = 12.9%
Banks = 16.5%
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Bank Widening Particularly Evident in Europe
At 2011 peak, CDS indicated one-third of European banks would default within 5 yrs
Recent tightening, but spreads still imply one-fifth will default (over next 5 yrs)
European CDS Indices Banks and Corporates
(bps)
050
100150200250300
350400450500
Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12
Bank Index Value Corp Weighted Index Value
Current (Sep 12) 5 yr PD
Corp = 13.1%
Banks = 20.8%
Second Peak (5 yr PD)
Corp = 20.5% (Oct 11)
Banks = 33.4% (Nov 11)
First Peak (5 yr PD)
Corp = 32.6% (Dec 08)
Banks = 20.2% (Mar 09)
Low (5 yr PD)
Corp = 3.9% (Jun 07)
Banks = 0.7% (Dec 06)
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Sovereign CDS Volatile Since September 2008
Over past year, 5-yr. CDS-implied PD has roughly halved (~20% down to ~10%)
Difficult to backtest historically, given low incidences of sovereign default
Developed Sovereigns (ex. Greece) CDS Spreads
0
50
100
150
200
250
300
Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12
Source: Fitch Solutions
(bps)
Current (Sep 12)
Spread = 127 bps
PD (5 yr) = 10.2%
Second Peak (Nov 11)
Spread = 280 bps
PD (5 yr) = 21.2%
First Peak (Feb 09)
Spread = 197 bps
PD (5 yr) = 15.4%
Low (Jun 07)
Spread = 2 bps
PD (5 yr) = 0.2%
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Distressed Spread Levels: Greece vs. Ireland
Both reached distressed trading levels of 1,000 bps
Ireland was an apparent false positive subsequent sharp tightening of spreads
Greece vs. Ireland CDS Spreads
0200400600800
1,0001,200
1,4001,6001,8002,000
Dec-07 Aug-08 Apr-09 Dec-09 Aug-10 Apr-11 Dec-11 Aug-12
Source: Fitch Solutions
Greece (Hellenic Republic of) Ireland (Republic of)(bps)
Current (Sep 12)
GreeceSpread = 11,775 bpsPD (5 yr) > 100%
IrelandSpread = 295 bpsPD = 22%
Jul 2011
Ireland hits 1250 bps
PD (5 yr) = 69%
Feb 2009 PD (5 yr)
Ireland = 29%
Greece = 20%
Jun 2010
Greece hits 1000 bps
PD (5 yr) = 60%
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Future Events that May Affect Sovereign CDS
Oct. 1819 European Council (banking union, Greece)Nov. 1213 Eurogroup/ECOFIN (EU finance ministers)Dec. 34 Eurogroup/ECOFIN (EU finance ministers)Dec. 1314 European Council (vote on banking union)December Single-supervisory mechanism plan
Spring 2013 Italian elections
Sept. 2013 German elections
Several Decision Points Within Eurozone
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Drivers of Disconnects in Spreads vs. Fundamentals
Total return orientation of market participants Focus on MTM value of CDS positions
Not necessarily reflective of longer-term credit risk
CDS pricing can be driven by factors not directly related to credit fundamentals
Liquidity conditions
Counterparty risk
Risk aversionof market participants (i.e., risk-neutrality assumption)
Leverage (i.e., function of margin)
As the markets came under increasing strain on account of the financial turmoil,liquidity in the CDS markets also began to dry up, raising doubts as to their value as
an indicator of risk and funding costs.
European Central Bank, Augu st 2009
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Risk Management Implications
CDS spreads can provide timely, market-based indicators of risk
Valuation, active portfolio management, and assessing funding conditions
In some cases, spreads lead observable credit deterioration (Monolines)
Useful informational content relative to other analytical tools (e.g., identifying outliers)
However, important to recognize the potential for:
False positives (REITs)
False negatives (Financial Institution credit events)
Volatility
Costs of false positives Expensive hedge
Opportunity cost, if sold off positions
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