Credit Contagion from Counterparty Risk

Abstract

Standard risk models cannot explain the observed clustering of default, sometimes described as credit This paper provides the first empirical analysis of contagion via direct counterparty effects. We find that bankruptcy announcements cause negative abnormal equity returns and increases in CDS spreads for creditors. In addition, creditors with large exposures are more likely to suffer from financial distress later. This suggests that counterparty risk is a potential additional channel of contagion. Indeed, the fear of counterparty defaults among financial institutions explains the sudden worsening of the crisis after the Lehman bankruptcy in September 2008.