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

Credit default swaps (CDS) are derivative contracts that are widely used as tools for credit risk management. However, in recent years, concerns have been raised about whether CDS trading itself affects the credit risk of the reference entities. We use a unique, comprehensive sample covering CDS trading of 901 North American corporate issuers, between June 1997 and April 2009, to address this question. We find that the probability of both a credit rating downgrade and bankruptcy increase, with large economic magnitudes, after the inception of CDS trading. This finding is robust to controlling for the endogeneity of CDS trading. Beyond the CDS introduction effect, we show that firms with relatively larger amounts of CDS contracts outstanding, and those with relatively more “no restructuring” contracts than other types of CDS contracts covering restructuring, are more adversely affected by CDS trading. Moreover, the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure for the resolution of financial distress