Systemic Credit Risk: What Is the Market Telling Us?

The ongoing subprime crisis raises many concerns about the possibility of even more widespread credit shocks. We describe a simple linear version of a sophisticated model that can be used to extract information about macroeconomic credit risk from the prices of tranches of liquid credit indices. The market appears to price three types of credit risk: idiosyncratic risk at the level of individual companies, sectorwide risk at the level of companies within an industry, and economywide or systemic risk. We applied the model to the recent behavior of tranches in the U.S. and European credit derivatives markets and show that the current crisis has more than twice the systemic risk of the automotive-downgrade credit crisis of May 2005.The dramatic meltdown in the subprime market in the summer of 2007 raised many red flags among market participants about their potential exposure to broad, systemic (economywide) credit shocks. The concerns resulted in dramatic declines in market liquidity, restricted access to credit, flights to quality, sharply increased market volatility, and larger risk premiums in many financial markets. Thus, the prices of the most credit sensitive securities in the market may actually play the role of “the canary in the coal mine” in providing information about how market participants collectively assess the risk of systemic or macroeconomic credit shocks. For the study reported in this article, we used the prices of indexed credit derivatives to extract market expectations about the nature and magnitude of the credit risks facing financial markets. Since the inception of indexed credit derivatives in 2002, this market has exploded in size and participation. Broad indices are now traded for the U.S. (Markit CDX) and European (Markit iTraxx) credit markets, which usually have high liquidity, and indices are traded to a lesser degree for the Japanese and U.K. credit markets. As of the end of 2007, the investment-grade CDX index was in its ninth generation and iTraxx, its European counterpart, was in its eighth generation. Even more striking than the success of the indices, however, is the launch and success of tranches on the indices. Tranches can be best thought of as call spreads on the credit losses of a portfolio. Investors can use tranches to control their exposure to particular loss thresholds. To extract the information from these credit derivatives, we first developed a simple linearized version of a sophisticated collateralized debt obligation pricing model. This three-jump model is calibrated directly to the traded spreads of tranches and indices. The model allows for the possibility that credit spreads might be a composite of several different types of credit risk. For the study described here, we fit the linearized version of the model to the market prices of the credit indices and tranches. Using current data for both investment-grade and high-yield indices, we found that the market anticipates three types of credit risk: idiosyncratic credit events, sectorwide credit events, and economywide credit events. What is particularly striking is that the nature of systemic credit risk appears to have changed dramatically. Systemic credit risk was only a small percentage of total credit risk during the automotive-downgrade credit crisis of May 2005. In the 2007 subprime crisis, however, systemic credit risk ballooned, and it now approximates the size of the idiosyncratic component of credit spreads. The findings argue that the current credit crisis differs in a fundamental way from previous credit events. An important implication of this finding is that credit risk premiums in financial markets may remain at high levels in the future, which would lead to significantly higher costs of debt for many companies and sectors. Another key implication is that some credit-modeling tools that are widely used in practice may severely underestimate the actual risk exposure of credit portfolios. A downside implication of the shifting trend in the nature of credit risk is that traditional risk management strategies, such as portfolio diversification, may be less effective in the future in controlling credit risk exposure. On the upside, from a strategic perspective, combinations of tranches allow a manager to directly implement a view on one of the three macro spreads.