The case for the prosecution

By A.P. | LONDON

AMONG the welter of papers presented at the AEA meetings in San Diego this past weekend was one to make opponents of financial innovation cheer. The paper, by Marti Subrahmanyan of New York University, Dragon Yongjun Tang of the University of Hong Kong and Sarah Qian Wang of the University of Warwick, looks at the effects of credit-default swaps (CDSs) on the companies these instruments were written on.

The authors used a database of North American CDS transaction records that ran from 1997 to 2009, and found that the odds of bankruptcy rose steeply for firms after CDSs started being traded, and decreased when the CDSs expired. Credit ratings dropped by half a notch, on average, in the two years after the instruments start trading. The authors control for the possibility that credit-default swaps are being written because investors anticipate that firms are going to get into trouble, and find that the relationship between CDS trading and higher bankruptcy risk appears to be causal.

How to explain this effect? One explanation is that CDSs make it likelier that firms get into financial distress. By making it safer for lenders to extend credit to companies on which insurance can be bought, CDSs enable these firms to take on more leverage, which increases the risk of a blow up. Another explanation is that CDSs make it more difficult for firms that get into distress to navigate their way out of trouble. Creditors are less inclined to be forgiving if they have an insurance policy to collect on; and CDS trading appears to lead to an increase in the number of lending relationships that a company has, which makes it harder for creditors to co-ordinate with each other.

All of which looks pretty damning. But as the authors themselves say at the end, it is not proof that CDSs are inherently bad. The paper indicates that CDSs increase the amount of debt available to reference companies, which is sort of the point. The real question is what the scale of that increase is. If firms take on too much debt, it's a rotten outcome. If firms can take on debt that then funds productive projects, it's a decent outcome. That in turn suggests that CDSs can be more or less useful at different points of the cycle. Just as they have the potential to amplify leverage dangerously when credit conditions are too loose, they may help to facilitate borrowing when credit is too tight.