CDS Spreads Performed Unevenly as Indicators of Default Risk During Crisis

by: Research Recap

During the recent financial crisis, credit default swap (CDS) spreads indicated an elevated risk of default that, for some sectors, was ultimately not borne out by subsequent experience, according to a Fitch Ratings report.

In its study, Fitch analyzed the performance of CDS spreads as market-implied indicators of default risk for more than 100 companies across five U.S. industry sectors that experienced pronounced market pressure during the credit crisis: monoline insurers, real estate investment trusts (REITs), homebuilders, banks, and insurance companies. All of the credits studied were rated investment grade as of June 30, 2007.

Fitch’s analysis illustrates that overall performance of CDS spreads during the crisis period was mixed.

For example, widening spreads proved to lead the severe distress that occurred among monolines, but appeared to generate “false positives” for homebuilders and REITs, sectors that as a whole experienced relatively mild erosion in credit fundamentals and a considerable tightening in CDS spreads after reaching their respective peaks in late 2008.

Similarly, although CDS spreads also widened markedly for financial services firms during the height of the crisis, only one credit event (Washington Mutual) occurred among the approximately 60 U.S. bank and insurance companies sampled. This discrepancy suggests that CDS markets might not have fully anticipated the significant role of external support (e.g. government assistance, acquisition by other financial institutions) in mitigating risks to debtholders.

“While CDS spreads can provide a dynamic, market-based view on a credit, it is important to keep in mind that CDS pricing can be driven by a number of factors not directly related to an entity’s fundamental creditworthiness” said Robert Grossman, Group Managing Director, Fitch Macro Credit Research group.

For details, see the full report CDS Spreads and Default Risk: Interpreting the Signals (Premium)