Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk

Abstract

Concerns have been raised, especially since the global financial crisis, about whether trading in credit default swaps (CDS) increases the credit risk of the reference entities. This study examines this issue by quantifying the impact of CDS trading on the credit risk of firms. We use a unique, comprehensive sample covering 901 CDS introductions on North American corporate issuers between June 1997 and April 2009 to address this question. We present evidence that the probability of a credit downgrade and of bankruptcy both increase after the inception of CDS trading. The effect is robust to controlling for the endogeneity of CDS introduction, i.e., the possibility that firms selected for CDS trading are more likely to suffer a subsequent deterioration in creditworthiness. We show that the CDS-protected lenders' reluctance to restructure is the most likely cause of the increase in credit risk. We present evidence that firms with relatively large amounts of CDS contracts outstanding, and those with "No Restructuring" contracts, are more likely to be adversely affected by CDS trading. We also document that CDS trading increases the level of participation of bank lenders to the firm. Our findings are broadly consistent with the predictions of the "empty creditor" model of Bolton and Oehmke (2011 ABSTRACTConcerns have been raised, especially since the global financial crisis, about whether trading in credit default swaps (CDS) increases the credit risk of the reference entities. This study examines this issue by quantifying the impact of CDS trading on the credit risk of firms. We use a unique, comprehensive sample covering 901 CDS introductions on North American corporate issuers between June 1997 and April 2009 to address this question. We present evidence that the probability of a credit downgrade and of bankruptcy both increase after the inception of CDS trading. The effect is robust to controlling for the endogeneity of CDS introduction, i.e., the possibility that firms selected for CDS trading are more likely to suffer a subsequent deterioration in creditworthiness. We show that the CDS-protected lenders' reluctance to restructure is the most likely cause of the increase in credit risk. We present evidence that firms with relatively large amounts of CDS contracts outstanding, and those with "No Restructuring" contracts, are more likely to be adversely affected by CDS trading. We also document that CDS trading increases the level of participation of bank lenders to the firm. Our findings are broadly consistent with the predictions of the "empty creditor" model of Bolton and Oehmke (2011).

The externalities of credit default swaps on stock return synchronicity

“…They show that firm leverage and debt maturity increase after the inception of CDS trading. Subrahmanyam et al (2014) show empirically that firms are more likely to go bankrupt after the initiation of CDS trading on their debt. Martin and Roychowdhury (2015) associate the onset of CDS trading with changes in accounting practices and report evidence that firms' accounting conservatism declines due to reduced monitoring efforts by lenders.…”

“…***,** Statistically significant at 1%, and 5% levels, respectively. Martin & Roychowdhury, 2015;Saretto & Tookes, 2013;Subrahmanyam et al, 2014Subrahmanyam et al, , 2017, we address the endogeneity issue by conducting DID analysis with matched sample, placebo test, and instrumental variable regressions.…”

“…However, the existing research on the impact of CDS trading all faces the potential endogeneity issue (Ashcraft & Santos, 2009;Kim et al, 2018;Martin & Roychowdhury, 2015;Saretto & Tookes, 2013;Subrahmanyam et al, 2014Subrahmanyam et al, , 2017. One of the concerns is that stock return synchronicity and sales to CDS reference customers are jointly determined.…”

Credit Insurance, Distress Resolution Costs, and Bond Spreads

“…Next, we instrument for CDS insurance using the average Tier 1 capital adequacy ratio of the firm's affiliated institutions (lenders and bond underwriters). The rationale for this instrument, as articulated by Subrahmanyam et al (2014), is that institutions with higher capital adequacy ratios will have less need to hedge their exposure to a borrower using CDS, thereby reducing the demand for CDS insurance on their borrowers. Thus, the Tier 1 capital ratio is likely to be negatively correlated with CDS insurance, but unlikely to be correlated with bond spreads.…”

“…These models predict that bond spreads should increase with renegotiation frictions as impediments to renegotiation increase distress resolution costs. Subrahmanyam, Tang, and Wang (2014) find that the introduction of CDS trading increases the underlying firm's bankruptcy risk implying that CDS insurance increases distress resolution costs. 1 Thus, to the extent that CDS insurance impedes…”