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 following up on its recent study analyzing the performance of credit default swap (CDS) spreads as indicators of default risk for U.S. sectors that incurred pronounced market volatility during the financial crisis (see Fitch Research on “CDS Spreads and Default Risk: Interpreting the Signals,” dated Oct. 12, 2010, available on Fitch’s web site at www.fitchratings.com). More specifically, this report analyzes the CDS spread history and implied annual probability of default (PD) for the U.S. broker-dealers over the past several years (see the Appendix on page 3 for methodology). The prior study, which focused on the North American bank, insurance, monoline insurance, real estate investment trust, and homebuilder sectors, did not address U.S. broker-dealers given their small sample size. In effect, only two out of five entities within this sector continued to operate independently after year-end 2008.
Financial Institutions Sector CDS Spreads and Implied PD
(bps) Banks (Excluding Broker-Dealers) Financial Institutions (Including Broker-Dealers)

Analysts
Robert J. Grossman +1 212 908-0535
robert.grossman@fitchratings.com

Martin Hansen +1 212 908-9190
martin.hansen@fitchratings.com

Related Research
 CDS Spreads and Default Risk: Interpreting the Signals, Oct. 12, 2010  Credit Derivatives and Margin: Under the Radar? Aug. 11, 2010

450 400 350 300 250 200 150 100 50 0

CDS spread (October 2007) = 50 bps Implied PD = 0.8%

CDS spread (September 2008) = 425 bps Implied PD = 7.1%

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

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November 8, 2010

CDS spreads were relatively low for an extended period of time (see the chart above).. Lehman Brothers Holdings Inc. average monthly CDS spreads for the five broker-dealers in the cohort were 34 bps. Interestingly.1%. Although several of the institutions in the sample received extraordinary government support (e. Morgan Stanley 800 700 600 500 400 300 200 100 0 (bps) March 2008 CDS spreads = 274 bps Implied PD = 4. Sources: Fitch Ratings and Fitch Solutions.    2 CDS Spreads and Default Risk November 8.e Lehman and Washington Mutual). as spreads on Morgan Stanley exceeded 700 bps in October 2008. the highest CDS spread observed during the period of study occurred after both the Bear Stearns and Merrill Lynch acquisitions and the Lehman bankruptcy. 2010 .6% October 2007 CDS spreads = 68 bps Implied PD = 1. coincident with the Bear Stearns acquisition.1% 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.g. akin to a realized default rate of 6. Broker-Dealer CDS Spreads by Entity Goldman Sachs Group Merrill Lynch & Co. a 2. However.6%) fell to an average of 139 bps (or. Spreads subsequently tightened. their senior debt obligations continued to perform and thus did not trigger a CDS credit event despite these institutions’ weakened financial condition. More specifically. Bear Stearns Companies Inc. From January 2006 through October 2007. several events of distress affected the broker-dealers over the ensuing 12-month period (e. the March 2008 average spread of 274 bps (or a CDS-implied PD of 4. U. The first prominent peak in broker-dealer CDS spreads occurred in March 2008.3% CDS-implied PD) in May 2008 for the remaining four broker-dealers in the sample. As of October 2007. government assistance or acquisition by another financial institution) during the crisis. Inc. the agreement by JP Morgan Chase to acquire Bear Stearns in March 2008.S.g. the Lehman bankruptcy. coincident with the two credit events experienced within the sector during the observation period.7% for the sector as a whole over that 12-month period. roughly halving over the next two months. Broker-Dealers (A Drill-Down on Individual Entities)  Prior to the crisis. the market-implied annual PD for the broker-dealers as a group was 1. and the agreement by Bank of America to acquire Merrill Lynch in September 2008).Financial Institutions sample experienced a credit event (i.   Financial institution spreads ultimately peaked in September 2008.

However.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. spread values are potentially sensitive to market liquidity. Additionally. CDS spreads do not necessarily reflect a longer-term horizon (e. 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. 2010 3 . which could contribute to directional spread momentum. protection seller) and another counterparty that is in a short position (i.   CDS Spreads and Default Risk November 8. the time value of money.g. including the use of fixed (rather than stochastic) recovery rates and risk neutrality. such as the high leverage inherent in swaps.e protection buyer). This study derives CDS-implied PDs based on a loss severity assumption of 60%. since CDS pricing reflects a transaction between one counterparty that is long credit risk (i. 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.0%. if assuming a 60% loss severity (or 40% recovery rate). counterparty risk. namely that CDS spreads do not embed a risk premium beyond compensation for expected or average credit losses. there are a number of caveats in using this formula as the basis for estimating PD:  Several simplifying assumptions underpin this formula.S. then an annual CDS spread of 120 bps would imply a one-year PD of 2. since many market participants have a total return orientation based on shorter-term changes in the mark-to-market value of CDS positions. one year) of fundamental credit risk. Since CDS pricing is dependent on trading activity. This approach is both tractable and directly relatable to the credit performance of the underlying reference entities. As an example.e. High-Yield Default Index in 2008 and 2009. and technical factors.

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