Financial Institutions

Special Report
CDS Spreads and Default Risk
U.S. Broker-Dealers
In response to interest received from several market participants, Fitch Ratings is
Analysts
following up on its recent study analyzing the performance of credit default swap (CDS)
Robert J. Grossman spreads as indicators of default risk for U.S. sectors that incurred pronounced market
+1 212 908-0535 volatility during the financial crisis (see Fitch Research on “CDS Spreads and Default
robert.grossman@fitchratings.com
Risk: Interpreting the Signals,” dated Oct. 12, 2010, available on Fitch’s web site at
Martin Hansen www.fitchratings.com). More specifically, this report analyzes the CDS spread history
+1 212 908-9190 and implied annual probability of default (PD) for the U.S. broker-dealers over the past
martin.hansen@fitchratings.com
several years (see the Appendix on page 3 for methodology).
The prior study, which focused on the North American bank, insurance, monoline
Related Research insurance, real estate investment trust, and homebuilder sectors, did not address U.S.
 CDS Spreads and Default Risk: broker-dealers given their small sample size. In effect, only two out of five entities
Interpreting the Signals, Oct. 12, within this sector continued to operate independently after year-end 2008.
2010
 Credit Derivatives and Margin:
Under the Radar? Aug. 11, 2010 Financial Institutions Sector CDS Spreads and Implied PD

Banks (Excluding Broker-Dealers) Financial Institutions (Including Broker-Dealers)

(bps)
450
400
350 CDS spread (October 2007) = 50 bps CDS spread (September 2008) = 425 bps
Implied PD = 0.8% Implied PD = 7.1%
300
250
200
150
100
50
0
6/07 12/07 6/08 12/08 6/09 12/09 6/10
Note: Lehman Brothers Holdings Inc. and Washington Mutual, Inc. experienced CDS credit events during Septermber 2008,
coincident with the peak in CDS spreads for the U.S. financial institutions cohort during the observation period. If excluding
Lehman and Washington Mutual spread observations from the Septermber 2008 analysis, the financial institution sector's CDS
spreads would have been 275 basis points, or an implied annual default probability of 4.6%.
Sources: Fitch Ratings and Fitch Solutions.

Given this data limitation, the follow-up analysis below: aggregates the broker-dealer
CDS spreads with those of the 25 banks from the October study to create a broader
financial institutions sample (see the chart above); provides spread histories for the five
U.S. broker-dealers on a name-by-name basis (see the chart on page 2). The resulting
findings are consistent with the October study, namely that the overall performance of
CDS spreads as indicators of default risk was mixed over the crisis period.

Financial Institutions (Sector as a Whole)

 Relative to the bank-only sample from the October study, CDS spreads for the
broader financial institutions sample (i.e. inclusive of the U.S. broker-dealers)
appear to be marginally higher but strongly correlated.
 As of October 2007, average CDS spreads for the financial institutions sector were
50 basis points (bps), implying an annual PD of less than 1% (if assuming a 60% loss
severity). However, during the ensuing year, two of the 30 entities within the

www.fitchratings.com November 8, 2010

 Financial Institutions
sample experienced a credit event (i.e Lehman and Washington Mutual), akin to a
realized default rate of 6.7% for the sector as a whole over that 12-month period.
 Financial institution spreads ultimately peaked in September 2008, coincident with
the two credit events experienced within the sector during the observation period.
 Although several of the institutions in the sample received extraordinary
government support (e.g. government assistance or acquisition by another financial
institution) during the crisis, their senior debt obligations continued to perform and
thus did not trigger a CDS credit event despite these institutions’ weakened
financial condition.

U.S. Broker-Dealer CDS Spreads by Entity

Goldman Sachs Group Lehman Brothers Holdings Inc.
Merrill Lynch & Co., Inc. Morgan Stanley
Bear Stearns Companies Inc.
(bps)
800
700
March 2008
600 CDS spreads = 274 bps
Implied PD = 4.6%
500
400 October 2007
CDS spreads = 68 bps
300
Implied PD = 1.1%
200
100
0

1/06 4/06 7/06 10/06 1/07 4/07 7/07 10/07 1/08 4/08 7/08 10/08 1/09 4/09 7/09 10/09 1/10 4/10 7/10 10/10
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.
Sources: Fitch Ratings and Fitch Solutions.

Broker-Dealers (A Drill-Down on Individual Entities)

 Prior to the crisis, CDS spreads were relatively low for an extended period of time
(see the chart above). From January 2006 through October 2007, average monthly
CDS spreads for the five broker-dealers in the cohort were 34 bps.
 As of October 2007, the market-implied annual PD for the broker-dealers as a group
was 1.1%. However, several events of distress affected the broker-dealers over the
ensuing 12-month period (e.g. the agreement by JP Morgan Chase to acquire Bear
Stearns in March 2008; the Lehman bankruptcy; and the agreement by Bank of
America to acquire Merrill Lynch in September 2008).
 The first prominent peak in broker-dealer CDS spreads occurred in March 2008,
coincident with the Bear Stearns acquisition. Spreads subsequently tightened, roughly
halving over the next two months. More specifically, the March 2008 average spread
of 274 bps (or a CDS-implied PD of 4.6%) fell to an average of
139 bps (or, a 2.3% CDS-implied PD) in May 2008 for the remaining four broker-dealers
in the sample.
 Interestingly, the highest CDS spread observed during the period of study occurred
after both the Bear Stearns and Merrill Lynch acquisitions and the Lehman
bankruptcy, as spreads on Morgan Stanley exceeded 700 bps in October 2008.

2 CDS Spreads and Default Risk November 8, 2010

 Financial Institutions
Appendix: Methodology
CDS spread data represent monthly averages of daily spread observations. To estimate
the default risk implied by CDS spreads at a given point in time, the average spread for
the entities in each sector is calculated and then converted to a PD value through the
following simple formula:

PD (one year) = CDS spread (annualized)/loss severity.

As an example, if assuming a 60% loss severity (or 40% recovery rate), then an annual
CDS spread of 120 bps would imply a one-year PD of 2.0%.

This study derives CDS-implied PDs based on a loss severity assumption of 60%,
consistent with common convention for this type of calculation and roughly in line with
both the average outcome of CDS auctions following credit events over the past few
years and realized recovery rates on the Fitch U.S. High-Yield Default Index in 2008
and 2009.
This approach is both tractable and directly relatable to the credit performance of the
underlying reference entities, since CDS pricing reflects a transaction between one
counterparty that is long credit risk (i.e. protection seller) and another counterparty
that is in a short position (i.e protection buyer).
However, there are a number of caveats in using this formula as the basis for
estimating PD:

 Several simplifying assumptions underpin this formula, including the use of fixed
(rather than stochastic) recovery rates and risk neutrality, namely that CDS spreads
do not embed a risk premium beyond compensation for expected or average credit
losses.
 Since CDS pricing is dependent on trading activity, spread values are potentially
sensitive to market liquidity, counterparty risk, the time value of money, and
technical factors, such as the high leverage inherent in swaps, which could
contribute to directional spread momentum.
 Additionally, since many market participants have a total return orientation based
on shorter-term changes in the mark-to-market value of CDS positions, CDS spreads
do not necessarily reflect a longer-term horizon (e.g. one year) of fundamental
credit risk.

CDS Spreads and Default Risk November 8, 2010 3

 Financial Institutions

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4 CDS Spreads and Default Risk November 8, 2010