Marti G. Subrahmanyam, Dragon Yongjun Tang, and Sarah Qian-Wang
Does the Tail Wag the Dog?: The Effect of Credit Default Swaps on Credit Risk
Review of Financial Studies | Volume 27, Issue 10 (Oct 2014), 2927-2960

The credit default swaps (CDS) market experienced exponential growth in 2000s, as it gradually became an effective tool for hedging, transferring and trading credit risk. However, the 2008 credit crisis highlighted the potential deleterious effects of over-the-counter derivatives on the real economy. It became abundantly clear that CDS may change the debtor-creditor relationship if creditors hedge or over-hedge their exposure by purchasing CDS of their borrowers. As a consequence, CDS-protected creditors have greater bargaining power and tend to be tougher in the process of restructuring. They may even have an incentive to push the borrowing firm into bankruptcy to trigger a payment from their CDS position, which increases the bankruptcy risk of the firm, ex-ante. we empirically examine the effects of CDS trading on the credit risk of the reference firms.

Credit risk increases after CDS introduction

We form our sample of CDS firms from multiple, leading data sources, including the GFI Group, CreditTrade, and Markit using transactions data, augmented with dealer quotes. We further construct the list of bankruptcies from New Generation Research's Public and Major Company Database (www.BankruptcyData.com), the Altman-NYU Salomon Center Bankruptcy List, the Mergent Fixed Income Securities Database (FISD), the UCLA-LoPucki Bankruptcy Research Database, and Moody's Annual Reports on Bankruptcy and Recovery. We then link the bankruptcy dataset with our CDS sample so as to identify the bankrupt firms that had CDS trading prior to their bankruptcy filings. In our final sample, we have 901 firms that have CDS traded on their debt during 1997-2009, of which 60 subsequently filed for bankruptcy protection. Additionally, we rely on CRSP, Compustat, FISD, and S&P to obtain firm accounting, financial, or credit rating information.

In Figure 1, we compare the distribution of credit ratings in the year preceding the introduction of CDS trading (year t-1) with the rating distribution two years after that (year t +2), for all firms with such contracts traded at some point in our sample. Figure 1 displays a discernible shift to lower credit ratings after the introduction of CDS trading. Whereas the proportion of BBB-rated firms is approximately the same, both before and after CDS trading begins, the proportion of AA-rated and A-rated firms clearly decreases. At the same time, the proportion of non-investment-grade and unrated firms increases.

1: Credit rating distributions before and after CDS introductions.
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There is a discernible shift to lower credit ratings after the introduction of CDS trading.

We then model the probability of bankruptcy and investigate if CDS firms indeed have higher bankruptcy risk. However, to infer whether CDS trading causes a decrease in credit quality, we must consider the possibility that firms may be selected into CDS trading based on certain characteristics. Moreover, CDS trading may be initiated on firms for which market participants anticipate an increase in credit risk. To address these concerns, we consider the joint determination of bankruptcy filings and CDS trading. We uncover the true effect of CDS trading by using instrumental variables that have a direct effect on CDS trading, but only affect bankruptcy via their effect on CDS trading. We employ two such instruments. The first is the foreign exchange hedging positions of lenders and bond underwriters. Lenders with larger foreign exchange hedging positions are more likely to trade the CDS of their borrowers. The second is the lenders' Tier One capital ratio. Banks with lower capital ratios have a greater need to hedge the credit risk of their borrowers via CDS. We indeed find that both instrumental variables are significant determinants of CDS trading. It also appears valid to exclude both from the credit risk predictions of borrowing firms because they only affect borrowers' credit risk via CDS market activities. Our results indicate that CDS firms' credit risk indeed increases after the inception of CDS trading. The economic magnitude of the CDS effect on bankruptcy risk is also large: The marginal effect of CDS trading on the probability of a downgrade is 0.39%, whereas the average downgrading probability is 0.59%. The likelihood of bankruptcy for our sample firms in any year is 0.14%. However, for an average firm in our sample, the bankruptcy risk increases by 0.33% after CDS trading is initiated.

Default risk conditional on distress is higher for CDS firms

Creditors will become tougher in the course of renegotiations with financially distressed borrowers if their potential losses are protected by CDS. To provide further evidence for this channel, we test if firms in financial distress are more likely to face bankruptcy when they are referenced in CDS trading. We identify distressed firms based on their stock market performance. If a firm's stock return is in the bottom 5% of the market for two consecutive years, we classify it as financially distressed in the third year. We then compare the probability of bankruptcy filing between CDS firms and non-CDS firms in this distressed sample. The results indicate that once a firm is in financial distress, it is more likely to file for bankruptcy if it is referenced by CDS trading. This effect is economically large. Compared to the default rate of 17.71% for all financially distressed firms, the marginal effect of CDS trading is 19.84%.

More severe effect for CDS that exclude restructuring as credit event

An alternative test for the tougher creditor channel relates to the definition of credit events that trigger payment of CDS contracts. CDS protected creditors will clearly prefer firms to declare bankruptcy rather than restructure their debt only if their total payoffs are greater under bankruptcy than under restructuring. One such situation arises when bankruptcy, but not restructuring, triggers a credit event for CDS contracts and generates payments to the CDS buyers. Under this setting, creditors' incentives to encourage borrower bankruptcy will be even stronger if restructuring is not covered by the CDS contracts. CDS-protected creditors will not have this incentive to the same degree if their CDS contracts also cover restructuring as a credit event. As expected, we find the probability of bankruptcy is positively associated with a “no-restructuring” clause in a CDS contract, which provides additional evidence for the presence of tougher CDS-protected creditors.

Number of lenders increases after CDS introduction

In addition to tough creditors causing bankruptcy on an individual basis, creditor coordination is another important consideration when it comes to debt workout. If firms borrow money from a larger group of lenders after the inception of CDS trading, then creditor coordination will be more difficult, and bankruptcy more likely, when firms seek to restructure. Lead banks will likely not wish to appear to be driving their borrowers into bankruptcy, as the resultant long-run reputational damage may outweigh the short-run gains from their CDS position. However, other lenders, such as hedge funds or private equity players, who are not similarly constrained, may exploit CDS trading more intensively. Therefore, CDS trading may affect the size and composition of a firm's lenders. We investigate the impact of the introduction of CDS on the creditor relationships of a firm based on DealScan LPC data. We find that CDS trading significantly increases the number of lenders for a firm. CDS firms have 2.4 more lenders than non-CDS firms two years following CDS introduction. Moreover, consistent with the finding in previous literature, we document that a firm's bankruptcy risk increases with the number of banking relationships.

Conclusion

We provide evidence that the trading of credit default swaps increases reference firms' bankruptcy risk by creating tougher creditors and more diverse lender base. Our study reveals a real consequence of CDS trading and contributes to a better understanding of this important derivative market. Although our findings indicate that firms become more vulnerable to bankruptcy, once CDS are traded on them, we emphasize that this finding does not imply that CDS trading necessarily reduces social welfare. The benefits of the higher firm leverage that results from the mitigation of risk may, for some agents, outweigh the greater bankruptcy costs. Future work can examine the trade-off between the potential benefits and the bankruptcy vulnerability caused by CDS, shedding light on the overall impact of CDS trading on allocative efficiency.