Systemic Credit Risk: What is the market telling us?

by Vineer Bhansali of PIMCO,
Robert Gingrich of PIMCO, and
Francis A. Longstaff of the University of California, Los Angeles

January 2008

Abstract: The ongoing subprime crisis raises many concerns about the possibility of much broader credit shocks in the economy. We use a simple linear version of the Longstaff and Rajan (2007) model to extract the information about macroeconomic credit risk embedded in the prices of tranches on the most-liquid credit indices. Three types of credit risk appear to be priced by the market: idiosyncratic risks at the level of individual firms, sectorwide risk at the level of correlated firms within the same industry group, and economywide or systemic risk. We apply the model to the recent behavior of tranches in the U.S. and European credit derivatives markets and show that the current credit crisis has more than twice the systemic risk of the May 2005 auto-downgrade credit crisis.

Published in: Financial Analysts Journal, Vol. 64, No. 4, (July-August 2008), pp. 16-24.

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