A Look Under the Hood How Banks Use Credit Default Swaps

Abstract

This note uses a unique dataset that matches banks' securities and loan portfolios to bank credit derivative transactions to characterize the basic features of how the largest banks in the U.S. use the single name CDS market in their investment portfolios.

A Model of Endogenous Debt Maturity with Heterogeneous Beliefs

“…Diamond (1991Diamond ( , 1993 and Houston and Venkataraman (1994) show that liquidity risk breaks the reliance on short-term debt and generates different debt maturity choices in the cross section based on credit ratings. 7 We show that multiple maturity debt is optimal without liquidation risk and firms do not use private information in any way.…”

“…9 Large firms typically raise capital from a syndicate of creditors rather than a single creditor even when considering private loan markets. Using supervisory data on bank holding companies, Caglio, Darst, and Parolin (2016) show that larger corporates borrow from, on average, 8 banks compared to small firms that tend to borrow from one. Brunnermeier and Oehmke (2013) show that financial firms' inability to commit to a maturity structure leads short-term debt to dilute long-term debt.…”

“…Definition 1 Equilibrium is a collection of the following non-negative items: debt prices, firm investment decision, investor cash holdings, debt holdings, and final consumption decisions that maximize firm profits given by (1), investor utility given by (6) subject to their budget constraints in (7), and both the goods and debt markets clear in all periods.…”

Half-full or half-empty? Financial institutions, CDS use, and corporate credit risk

“…The data are split according to whether the borrowers are CDS or non-CDS firms. 10 The annual growth rate of loans to CDS and non-CDS firms is 7.2% and 2.3%, respectively. Although the sample of banks in our study is small relative to overall population of U.S. banks, the FR-Y14 data collection covers roughly 73% of the total C&I lending done by all banks in the U.S. 11 The jump in total credit during the third quarter of 2012 is the result of additional banks being included in the CCAR supervisory exercise.…”

Credit Cycles, Securitization, and Credit Default Swaps

“…The evidence in Das et al (2014) suggests the advent of CDS was largely detrimental to firms because bond markets became less efficient and experienced no improvement in liquidity. Caglio et al (2016) report that banks sell more credit protection than they buy for the firms in their loan and securities portfolios, so doubling the bet instead of hedging. This is the opposite of what we should expect if the reason to use CDS were to hedge credit risk.…”