Wall Street-made financial instruments purportedly created to protect investors against default actually hasten corporate bankruptcies, according to a new study. And it’s not Occupy protesters bashing these credit default swaps (CDS) – the report comes from none other than the New York Society of Security Analysts. Its findings are as follows:
We present evidence that the probability of credit rating downgrade and the probability of bankruptcy both increase after the inception of CDS trading. […]
Lenders who insure themselves by buying CDS protection help push borrowers into bankruptcy, even though restructuring may be a better choice for the firm from the conventional (without CDS protection) lenders’ perspective.
The problem, say the authors, comes down to a basic conflict of interest – creditors holding the securities suddenly hold an actual stake in the firm’s failure.
CDS could affect bankruptcy risk through two channels associated with the empty creditor problem. The first and direct channel is the effect on the willingness to restructure the debt, whereby creditors (over)insured with CDS break the link between cash flow rights and control rights. Empty creditors are unwilling to restructure the firm even if doing so is efficient for debt value as they can profit significantly from their CDS positions. Several theoretical papers model the empty creditor issue. […]