If creditors selectively trade CDS linked to their borrowers, CDS positions can change the creditor-borrower relationship and play an important role in determining the borrower credit risk that determines CDS payoffs. On the one hand, CDS allow creditors to hedge their credit risk; therefore they may increase the supply of credit to the underlying firm. Such improved access to capital may increase borrowers' financial flexibility and resilience to financial distress.On the other hand, lenders may not be as vigilant in monitoring the borrowers once their credit exposures are hedged. Consequently, firms, in turn, may take on more risky projects. Furthermore, CDS-protected creditors are likely tougher during debt renegotiations, once the borrowers are in financial distress, by refusing debt workouts and making borrowers more vulnerable to bankruptcy….
the likelihood of a rating downgrade and the likelihood of bankruptcy of the reference firms both increase after CDS start trading
Anecdotal evidence suggests that CDS positions can play an important role in the process of distress resolution. To cite one such instance, CIT Group attempted to work out its debt from late 2008 to mid- 2009. In the event, however, some creditors with CDS protection rejected the firm's exchange offer. CIT Group eventually filed for Chapter 11 bankruptcy on November 1, 2009. Hu and Black (2008) term such CDS-protected debt-holders “empty creditors”, meaning that they have all the same legal rights as creditors, but do not have positive risk exposure to borrower default; hence, their financial interests are not aligned with those of other creditors who do not enjoy such protection. The empty creditor problem is formally modeled by Bolton and Oehmke (2011).8 Their model predicts that, under mild assumptions, lenders will choose to become empty creditors by buying CDS protection. Consequently, they will be tougher in debt renegotiation when the firm is under stress. Empty creditors are even willing to push the firm into bankruptcy if their total payoffs including CDS payments would be larger in that event. In their model, CDS sellers anticipate this empty creditor problem and price it into the CDS premium, but they cannot directly intervene in the debt renegotiation process (unless they buy bonds or loans so as to become creditors).
Our combined dataset contains contract terms that allow us to test a unique prediction of the empty creditor model. Specifically, we know for each CDS contract whether restructuring is covered as a credit event or not. Buyers of “no restructuring” CDS contracts will be paid only if the reference firm files for bankruptcy or there is a failure to pay. However, buyers of other types of CDS contracts that include restructuring as a credit event will be compensated even when the debt of the reference firm is restructured. Clearly, creditors with “no restructuring” CDS protection will have a stronger incentive to force bankruptcy than buyers of other CDS contracts without this restrictive clause. Indeed, we find that the effects of CDS trading are stronger when a larger fraction of the CDS contracts contain the “no restructuring” credit event clause