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. 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 credit rating downgrade and the probability 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 with upcoming deterioration in creditworthiness are more likely to be selected for CDS trading. 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 larger amounts of CDS contracts outstanding, and those with more 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).