Implicit Government Guarantee and the CDS Spreads

Abstract

It is commonly agreed that the government is more likely to step in and rescue some troubled companies labeled as “too big to fail” or “too interconnected to fail.” Since there is no formal contract between these companies and the government, this potential intervention is referred to as an implicit government guarantee. We propose a new approach of assessing and estimating the implicit government guarantee and analyze whether it is reflected in the CDS spreads. We define the implicit government guarantee for a given company as the probability that the government will bail it out in case of a default. Although the company’s size affects the likelihood of government intervention, we find that financial industry membership is a more important factor. Furthermore, we find that the implicit government guarantee is priced into the CDS spreads. The government guarantee for large companies reduces the CDS spread by 16.11 bps and for small companies only by 3.73 bps. Similarly, for the financial industry, we find that the government guarantee reduces the CDS spread by 76.29 bps and for the nonfinancial industry only by 7.50 bps.

TOPICS: Financial crises and financial market history, credit default swaps