Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk

52 Pages Posted: 13 Jan 2012 Last revised: 10 Sep 2013

See all articles by Marti G. Subrahmanyam

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics

Sarah Qian Wang

University of Warwick - Warwick Business School

Date Written: January 2012

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).

Suggested Citation

Subrahmanyam, Marti G. and Tang, Dragon Yongjun and Wang, Sarah Qian, Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk (January 2012). NYU Working Paper No. 2451/31421, Available at SSRN: https://ssrn.com/abstract=1983079

Marti G. Subrahmanyam (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics ( email )

KKL 1004
Pokfulam Road
Pokfulam
Hong Kong
(852)22194321 (Phone)

Sarah Qian Wang

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

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