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).

Do Credit Derivatives Lower the Value of Creditor Control Rights? Evidence from Debt Covenants

“…The dependent variables for our panel regressions using loan-initiation observations are various measures of covenant strictness. For the explanatory variables, we construct two CDS variables following Ashcraft and Santos (2009), Saretto and Tookes (2013) and Subrahmanyam, Tang and Wang (2014). One is CDS Trading, a dummy representing whether the borrower's debt has active CDS trading during the quarter of loan origination.…”

“…Karolyi (2013) shows that borrowing firms increase their operational risk after CDS begin trading on their debt. Subrahmanyam, Tang, and Wang (2014) find that after CDS trading begins, borrowers are more likely to be downgraded and more likely to file for bankruptcy. Arentsen, Mauer, Rosenlund, Zhang, and Zhao (2014) find similar evidence for mortgages.…”

“…regarding IVs.The first instrument, Lender Foreign Exchange Derivatives, is selected based on the existing literature, namely,Saretto and Tookes (2013) andSubrahmanyam, Tang and Wang (2014). This instrument is the amount of foreign exchange derivatives used for hedging (not trading) purposes relative to the total loans of the lead syndicate banks a firm has borrowed from during the past five years.…”

“…Bolton Under MR, the deliverable obligations are limited to those with maturities within 30 months of the CDS contract's maturity. Under MMR, the restriction on maturities is relaxed to 60 months for the restructured debt Subrahmanyam, Tang, and Wang (2014). provide more details on the restructuring clauses.…”

The role of managerial risk‐taking in the ‘rise and fall’ of the CDS market

“…Subrahmanyam et al . () posit that with the inception of CDS trading, the credit risk of such entities increases, as reflected in rating downgrades and significantly increased bankruptcies.…”