## The Use (and Abuse) of CDS Spreads During Distress

_IMF Working Papers, March 1, 2009_

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## Bibliographic details
- Authors: Carolyne Spackman, Manmohan Singh
- Published: March 1, 2009
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451872095.001

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### Summary
- Credit Default Swap spreads have been used as a leading indicator of distress.
- Default probabilities can be extracted from CDS spreads, but during distress it is important to take account of the stochastic nature of recovery value.
- Recent episodes of Landbanski, WAMU and Lehman illustrate that using the industry-standard fixed recovery rate assumption gives default probabilities that are low relative to those extracted from stochastic recovery value as proxied by the cheapest-to-deliver bonds.
- Financial institutions using fixed rate recovery assumptions could have a false sense of security, and could be faced with outsized losses with potential knock-on effects for other institutions.
- To ensure effective oversight of financial institutions, and to monitor the stability of the global financial system especially during distress, the stochastic nature of recovery rates needs to be incorporated.

### Key findings and evidence
- Using a fixed recovery rate assumption (industry standard) understates default probabilities during distress compared with models that incorporate stochastic recovery value.
- Cheapest-to-deliver (CTD) bond prices can be used to proxy stochastic recovery value and yield higher implied default probabilities than fixed-recovery models.
- Episodes cited as illustrative: Landbanski, WAMU, Lehman.

### Policy implications and recommendations
- Supervisors and financial institutions should incorporate the stochastic nature of recovery rates into models used for:
  - Extracting default probabilities from CDS spreads.
  - Risk assessment and capital planning during distress.
- Reliance on fixed recovery assumptions can create a false sense of security and increase systemic risk through underestimated counterparty exposures.
- Monitoring frameworks for the stability of the global financial system should include stochastic recovery-rate considerations, particularly in periods of heightened distress.

### Subject classification and keywords
- Subject: Asset prices, Bonds, Credit, Credit default swap, Currencies, Financial institutions, Money, Prices
- Keywords: Asset prices; Bonds; CDS contract; CDS market; CDS settlement; CDS spread; CDS spreads during distress; cheapest-to-deliver bonds; Credit; Credit default swap; credit event; CTD bond price information; Currencies; Global; market; probability of default; stochastic recovery rate; value; WP

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/the-use-and-abuse-of-cds-spreads-during-distress-22805_