Disrupted links between credit default swaps, bonds and equities during the GM and Ford crisis in 2005

We analyse the crisis experienced by General Motors (GM) and Ford following the downgrading of their credit ratings in May 2005 and its impact on the financial markets. At that time, the Credit Default Swap (CDS) premia of GM and Ford sharply increased; all other CDS premia also rose markedly, but stock markets hardly reacted. We try to determine if the usual links between CDS, bonds and stocks were affected by the crisis. To answer this question, we consider 5-year maturity CDS premia and stock prices for 120 major US and European firms, and construct a generic 5-year bond for each of these firms. We estimate nonlinear Vector Error-Correction Model (VECM) and Vector Autoregressive (VAR) model at the firm level. First, the results show that the CDS market has a lead over the bond market, confirming previous results by Blanco et al. (2005) and Zhu (2006), whereas the stock market tends to lead the CDS market. Second, we show that those markets were somewhat disconnected during the crisis, as their links were significantly loosened.