As big financial institutions such as Lehman Brothers fell into distress in 2008, a credit contagion spread through the financial industry, creating a credit drought for the economy as lenders retrenched and hoarded capital.
It has been less clear how credit contagion can spread through other industries, but research by George Washington’s Şenay Ağca, Georgetown’s Volodymyr Babich, Chicago Booth’s John R. Birge, and City University of Hong Kong’s Jing Wu suggests that credit shocks follow the supply chains of distressed companies.
Ağca, Babich, Birge, and Wu examined daily changes in credit default swap (CDS) spreads for all contracts with a five-year maturity between 2003 and 2014. A CDS is a derivative contract guaranteeing the owner a payout in the event that the borrower defaults. The contract’s price is known as the spread, which is the cost to insure against the default of $100 of the issuer’s debt. A widening spread signals that the market believes the issuer is more likely to default. Because the CDS market is deep and liquid, with information priced rapidly into the spread, the researchers argue that it is a better indicator of default expectations than laggard credit ratings or notes from bond analysts.
Take Ford Motor Company’s November 2008 earnings report, which highlighted massive losses, looming layoffs, and drastic cuts in capital spending. The CDS spreads linked to the company’s debt quickly widened, as one might expect. CDS spreads of American Axle & Manufacturing, a major Ford supplier, did the same, the researchers find. It makes sense that if Ford was slashing spending, its suppliers would have been suffering, they note.
But by contrast, CDS spreads were unchanged for companies with no relationship to either Ford or American Axle, such as semiconductor manufacturer Advanced Micro Devices. This suggests the mechanism by which contagion spreads is based on quantifiable business relationships, the researchers find.
They calculate that top-tier suppliers to companies experiencing negative credit events suffered widening spreads amounting to 44 to 71 basis points, or 0.44 to 0.71 percentage points. CDS spreads for second- and third-tier suppliers also widened, suggesting that “CDS markets pay close attention to supply chains, both to first and higher tiers,” the researchers write.
While the links between manufacturers and their suppliers can be complex, CDS investors seemed to understand them. The contagion effect on a specific supplier depends on its relationship with the distressed customer and on its own financial position and business diversification, according to the study. The findings offer some insight as to how credit risk infiltrates the financial system and suggest what investors could see during the next downturn.