Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk
Speaker
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 entity. This study examines this issue by quantifying the impact of CDS trading on the credit risk of firms, measured by both the probability of a future credit downgrade and the probability of bankruptcy. We use a unique, comprehensive sample covering 901 CDS contracts introduced for trading 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 less creditworthy firms, especially those with larger amounts of CDS contracts outstanding, and those with “No Restructuring” contracts, are more likely to be adversely affected by CDS trading. We also document the effect of CDS trading on 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). |
| Contact information: |
| Myra Lissenberg |
