Credit Contagion from Counterparty Risk

Standard credit risk models cannot explain the observed clustering of default, sometimes described as "credit contagion." This paper provides the first empirical analysis of credit contagion via direct counterparty effects. We examine the wealth effects of bankruptcy announcements on creditors using a unique database. On average, creditors experience severe negative abnormal equity returns and increases in CDS spreads. In addition, creditors are more likely to suffer from financial distress later. These effects are stronger for industrial creditors than financials. Simulations calibrated to these results indicate that counterparty risk can potentially explain the observed excess clustering of defaults. This suggests that counterparty risk is an important additional channel of credit contagion and that current portfolio credit risk models understate the likelihood of large losses