Systemic Risk in Bonds and Credit Derivatives - The Case of the Subprime Mortgage Crisis

We compare the impact of the Enron default, the WorldCom default, and the subprime mortgage crisis on CDS premia an on the market- and industry-wide default correlations implied by CDS premia and bond yield spreads. The results suggest that while the WorldCom crisis mainly affected firms from the communications sector, both the Enron and the subprime mortgage crisis constitute market-wide crises with a significant increase in correlation, measured as the copula lower-tail dependence. The subprime mortgage crisis has a particularly pronounced impact on financial institutions when correlation is measured from CDS premia. We attribute this finding to the relative riskiness of financial institutions: Even though default risk has increased disproportionately, the average financial institutions retains an investment grade rating. Therefore, numerous corporate debt issues profit from the flight-to-quality effect in spite of the issuers' sharply increased default risk.