Stochastic Cascades, Credit Contagion and Large Portfolio Losses

We analyze an interactive model of credit ratings where external shocks, initially affecting only a small number of firms, spread by a contagious chain reaction to the entire economy. Counterparty relationships along with discrete adjustments of credit ratings generate a transition mechanism that allows the financial distress of one firm to spill over to its business partners. Such as contagious infectious of financial distress constitutes a source of intrinsic risk for large portfolios of credit sensitive securities that cannot be "diversified away". We provide a complete characterization of the fluctuations of credit ratings in large economies when adjustments follow a threshold rule. We also analyze the effects of downgrading cascades on aggregate losses of credit portfolios. We show that the loss distribution has a power-law tail if the interaction between different companies is strong enough.