Credit Risk

Credit risk is the risk that a borrower won't pay you back. It applies to every bond you hold, every company you lend to, every bank deposit you make. Most of the time it's invisible. During financial crises, it becomes the only thing that matters.

The components of credit risk

Three variables drive credit risk exposure:

• Probability of Default (PD) — how likely is the borrower to fail to make payments? Driven by business model quality, debt levels, cash flow stability, and economic conditions.
• Loss Given Default (LGD) — if they default, how much do you lose? Senior secured creditors (first in line, backed by specific assets) typically recover 60–70%. Subordinated or unsecured creditors might recover 10–30%.
• Exposure at Default (EAD) — how much are you owed when default occurs?

Expected Loss = PD × LGD × EAD. This is the framework banks use to price every loan they make.

Credit default swaps — insurance on bonds

A Credit Default Swap (CDS) is effectively insurance against a borrower defaulting. The protection buyer pays a regular premium to the protection seller. If the borrower defaults, the seller compensates the buyer. CDS spreads (the annual premium) reflect the market's real-time assessment of default probability — wider spread = higher perceived risk.

CDS played a central role in the 2008 financial crisis. AIG had sold massive quantities of CDS protection on mortgage-backed securities, effectively insuring them against default. When those securities collapsed, AIG owed billions in payouts and had to be bailed out by the US government to prevent a cascade of counterparty failures across Wall Street.

Lehman Brothers — credit risk made catastrophic

In September 2008, Lehman Brothers — a 158-year-old investment bank with $600 billion in assets — filed for bankruptcy in 72 hours. The trigger: mortgage-backed securities on its balance sheet had collapsed in value, wiping out its equity. But the reason it became a catastrophe was counterparty credit risk. Hundreds of banks, hedge funds, and money market funds had credit exposure to Lehman — through loans, derivatives, repo agreements. When Lehman defaulted, the uncertainty about who was exposed to what froze credit markets globally. The interbank lending rate (LIBOR) spiked. Banks stopped lending to each other. The 2008 financial crisis became a solvency crisis, not just a housing crisis.