Study Shows CDS Trading Increases Bankruptcy Risk

In a previous post, we looked at the bankruptcy and re-structuring process through the court system.  We detailed that the debt holders are converted into equity holders.  Any debt holders with a 33% position have a blocking position to approve any deal.  At the same time, they can hedge their holdings by purchasing credit default swaps (CDS).  Since the recovery rates for a re-structuring range up to 65%, a March study by Marti Subrahmanyamy of New York University's Stern School of Business, Dragon Yongjun Tang and Sarah Qian Wang of the University of Hong Kong's School of Economics and Finance indicates that fully insured and over-insured investors push the company into bankruptcy to recover 100% of their bonds' value.  They are called empty creditors.  They have "an economic interest in the firm's claims but no risk alignment with the other bondholders..."  Companies with empty creditors have higher bankruptcy rates due to less monitoring.  This may lead to higher risk taking by the borrowers.  Finally, companies that have CDS traded on them have more debt holders or lenders.  This impedes the re-structuring process.

The authors analyzed data for 901 CDS for North American companies between June 1997 to April 2009.  Of the 1,628 firms that filed for bankruptcy, 60 had CDS traded.  They reviewed the 3,863 companies that had their credit rating downgraded by Standard & Poor's.  Statistical analysis confirmed the following after CDS began trading on those firms:

• Majority of firms are A or BBB rated
• S&P ratings fall for investment grade firms (A, AA or AAA) and more firms become non-investment grade (BBB and below)

When a company is the underlying for a CDS, it is more likely to be downgraded by a rating agency as a precursor to bankruptcy.  This occurs more readily when there are more CDS contracts traded and when re-structuring does not trigger a payout on the contact.  The probability of bankruptcy is 0.33% versus 0.14% for a non-CDS traded company.

The source for this article, with the authors' statistical analyses, can be accessed here.