Stochastic cascades, credit contagion, and large portfolio losses

We analyze an interactive model of credit ratings where external shocks 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. The spread of financial distress constitutes a source of intrinsic risk for large portfolios of credit sensitive securities that cannot be “diversified away”. We provide a characterization of the fluctuations of credit ratings in large economies when adjustments follow a threshold rule and analyze the effects of downgrading cascades on credit portfolios.