Market versus Contracting: Credit Default Swaps and Creditor Protection in Loans

Credit default swaps and corporate innovation

“…In the presence of stringent covenants, borrowing firms may curb risk taking in innovation to avoid covenant violations. To the extent that firms' debt covenants are loosened after CDS trading starts (Shan, Tang, and Winton, 2015), their ability and flexibility to experiment with novel projects should increase (Atanassov, 2015). Against this backdrop, we expect the CDS effect on innovation to be stronger for firms with more debt covenants that are loosened after the introduction of CDSs.…”

“…Specifically, we are interested in two types of loan covenants, i.e., secured debt and net worth covenants, which have been shown by Shan, Tang, and Winton (2015) to loosen upon the inception of the CDS market. 34 Firms with bank debt are then divided into two groups according to whether their loan contracts contain at least one of the two types of covenants over the five years before CDS trading starts.…”

“…Recent studies (e.g., Morrison, 2005) show that the onset of CDS trading weakens lenders' incentives to engage in costly monitoring and to intervene in borrowers' governance because lenders' claims can be insured via CDSs. Shan, Tang, and Winton (2015) find that covenants on a borrower's debt become less strict if there are CDS contracts referencing the borrower's debt at the time of loan initiation. In response to reduced lender monitoring, borrowing firms potentially have more opportunities to direct their efforts and resources toward more innovative projects that are riskier by nature.…”

“…Morrison (2005) and Parlour and Winton (2013) model that CDSs weaken insured lenders' monitoring and intervention incentives. Shan, Tang, and Winton (2015) reveal that lenders impose less restrictive debt covenants after CDS trade initiation, suggesting that CDSs substitute covenants for creditor protection. Bolton and Oehmke (2011) note that CDSs can turn insured lenders into "empty creditors", thereby increasing their bargaining power in debt renegotiation.…”

Credit Default Swaps, Financial Distress and Corporate Acquisitions

“…2 Secondly, because creditors transfer risk to CDS sellers, they may be less incentivized to monitor CDS firms (Morrison (2005)), resulting in weaker screening, debt terms (Shan, Tang, and Winton (2014) and Shan, Tang, and Winton (2015)), and discipline imposed on underperformance (Chakraborty, Chava, and Ganduri (2015)) than in the case of non-CDS firms, which is referred to as the weak monitoring hypothesis. For instance, CDS inception results in lending that is less secured (Shan, Tang, and Winton (2015)) and with less restrictive covenants (Shan, Tang, and Winton (2014)). Accordingly, whilst creditors appear generally to restrict borrowers' investment when debt covenants are violated (Chava and Roberts (2008) and Nini, Smith, and Sufi (2009)), Chakraborty, Chava, and Ganduri (2015) document that this is not the case for CDS firms.…”