Explaining CDS Prices Before and After the Lehman Default with a Simple Structural Model

We examine what determines CDS prices over 2005-2012. To do this, we calibrate Merton's model in a novel way that allows for deviations from lognormality. The model works well in cross-section and time-series, both within and out-of sample. It confirms that systematic equity volatility is the major determinant of CDS prices. Before the Lehman default, all firms have CDS prices that are close to those set by the model (with small variations due to illiquidity and earnings-uncertainty). After the default, some firms continue to have CDS prices at model-predicted levels, but others are now more-strongly influenced by idiosyncratic factors and have much higher prices.