Electronic copy available at: https:ssrn.comabstract=2973275 1
1. Introduction
A credit default swap CDS, a relatively recent financial innovation, pays its owner the face value of debt in the event of a borrower default. Since 1994, CDSs have grown into a multi-
trillion-dollar industry ISDA, 2013, but “there is a dearth of serious empirical studies” on the
implications of CDSs Stulz, 2010, p. 18. Hu and Black 2008 and Bolton and Oehmke 2011 theorize that after obtaining insurance for its asset upon the inception of CDS trade hereafter, CDS
inception, an “empty” lender continues to possess all the legal rights of a lender but has little skin left in the game. It could refuse debt workouts, making a distressed borrower more vulnerable to
bankruptcy Subrahmanyam, Tang, and Wang, 2014; Danis, 2016. It also begins shirking its
monitoring responsibility over the borrower’s activities Martin and Roychowdhury, 2015; Amiram, Beaver, Landsman, and Zhao, 2016. While the evidence of reduced lender monitoring
upon CDS inception is uncontroversial, the literature leaves an important issue unaddressed: how borrowers
’ real activities change in response to the altered debtor-creditor relation post–CDS inception?
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Also to be considered are the alternative mechanisms by which CDS inception leads to higher bankruptcy risk other than lenders
’ increased intransigence Augustin, Subrahmanyam, Tang, and Wang, 2014. We investigate these issues and examine changes in borrowers
’ investment policies following CDS inception.
We hypothesize that the borrower, upon observing the onset of CDS trading and subsequent weakening of the lender’s vigilance and monitoring, substitutes its safe assets with
more volatile ones to increase the value of call options built into shareholder investments Campello and Matta, 2012. We do not find, on average, results to support this hypothesis
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Anecdotal evidence suggests that firms react upon observing the onset of CDS trading. See the article, “Too big to ignore, Debt derivatives markets are encroaching on corporate finance decisions” in
CFO Magazine
available at http:www.cfo.comprintablearticle.cfm9821507.
Electronic copy available at: https:ssrn.comabstract=2973275 2
arguably because borrowers pursue more conservative policies facing more credible threat of foreclosure from empty lenders Subrahmanyam, Tang, and Wang, 2017 or because the
undiversified managers are reluctant to increase firm-specific risks Lambert, Larcker, and Verrecchia, 1991. However, the value and the convexity of managerial compensation increase
post –CDS inception. The resulting high convexity is associated with excessive dividend payouts
as well as increases in operating and bankruptcy risks. As such, our study provides evidence of changes in borrowers’ real activities post–CDS inception, if they are consistent with managers’
incentives. We respond to Stulz 2010 and Augustin, Subrahmanyam, Tang, and Wang 2014, who call for more thorough examination of changes in borrowers’ real activities as well as holistic
investigation of changes in borrowers’ stakeholders’ interests upon CDS inception. Asset volatility increases the value of
a firm’s equity because shareholders capture all of the upside in firm value beyond the face value of debt. When the volatility value dominates the in-
the-money value of call options, a volatility-enhancing project might benefit shareholders even when it has a negative net present value. Lenders, however, could lose from increased asset
volatility because shareholders bear no obligation to pay the difference when a firm’s value falls
below the face value of debt. To prevent such wealth transfer to shareholders, lenders attempt to constrain borrowers’ risky activities through covenants and active monitoring Fama and Miller,
1972; Jensen and Meckling, 1976; Smith and Warner, 1979. Lender monitoring and covenant enforcement, however, are costly activities Holmstrom
and Tirole, 1997; Sufi, 2007; Arentsen, Mauer, Rosenlund, Zhang, and Zhao, 2015. Having hedged its credit exposure upon CDS inception, a lender does not derive the same benefits from
those activities as before Morrison 2005; Arentsen et al. 2015. At the margin then, the lender can start shirking its monitoring responsibility and could impose lesser discipline upon borrowers in
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the event of a covenant violation Chakraborty, Chava, and Ganduri, 2015. Expecting reduced monitoring from the lead bank, the loan syndicate banks demand higher loan spreads Amiram,
Beaver, Landsman, and Zhao, 2016, and borrowers reduce accounting conservatism in their financial reporting Martin and Roychowdhury, 2015. In addition,
the lender’s asset is now assigned the risk of the CDS guarantor instead of that of the borrower Basel II, page 49, Article
141. The resultant change of the counterparty risk from borrower to CDS writer reduces the lender’s regulatory capital requirement, allowing it to expand its loan portfolio Shan, Tang, and
Yan, 2014. Such a portfolio expansion would further reduce lenders ’ monitoring effort per client.
A borrower would detect the weakening of the lender’s vigilance and monitoring upon the
onset of CDS trading Martin and Roychowdhury, 2015. The borrower could then substitutes its safe assets with more volatile ones to increase the value of call options built into shareholder
investments Campello and Matta, 2012. We test this hypothesis by examining post –CDS changes
in research and development RD outlays and expenditures on property, plant, and equipment, the proxies for risky and safe investments, respectively Kothari, Laguerre, and Leone, 2002; Shi,
2003; Coles, Daniel, and Naveen, 2006.
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We also examine the frequency of mergers and acquisitions MA. They are an ideal setting for our analysis because they are among the largest
firm investments and can intensify lender-shareholder conflicts. In addition, we examine excessive dividend payouts. They are arguably the most direct way to transfer wealth from lenders to
shareholders Kalay, 1982; Handjinicolaou and Kalay, 1984; Ahmed, Billings, Morton, and Stanford-Harris, 2002. These
changes in borrowers’ investment and financing policies could
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Relative to investments in tangible assets, corporate innovation is a highly risky and multi-stage endeavor with unpredictable returns Holmstrom, 1989. Shi 2003, p. 227 concludes that,
“for creditors, the RD risk dominates their
benefits.” While there no direct evidence exists of debt covenants constraining RD expenditures, studies show that strong creditor rights are associated with reduced RD spending Acharya, Amihud, and Litov, 2011; Seifert and
Gonenc, 2012.
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enrich shareholders at the expense of lenders, but they are constrained by lenders’ monitoring and
covenants Smith and Warner, 1979; Nash, Netter, and Poulsen, 2003; Bratton, 2006; Acharya and Subramanian, 2009; Brockman and Unlu, 2009; Nini, Smith, and Sufi, 2009.
We study changes in operating and financing policies for 546 firms whose CDSs started trading during the period 1992 to 2014. We, however, do not find evidence of asset substitution or
increases in dividend payouts, on average, after CDS inception. A theoretical framework by Arping 2014 on the consequences of CDS inception could explain our null results. After
diversifying its credit risk against the borrower, an empty lender could let renegotiations with the distressed borrower fail and force it into bankruptcy. Faced with a more credible threat of
foreclosure, the borrower can avoid actions detrimental to the lender’s interests. For example, the
borrower would pursue more conservative dividend policies to preserve cash, anticipating inflexible lender Subrahmanyam et al. 2017. Yet, this theory
does not consider managers’ incentives.
Another possible explanation for our null results is that the interests of risk-averse managers are largely aligned with those of lenders as far as the effects of asset volatility and
dividend payouts are concerned. Unlike shareholders, undiversified managers shun firm-specific risks Coles, Daniel, and Naveen, 2006. For example, managers reduce the perceived value of
stock and option holdings in their own firm when asset volatility increases Lambert, Larcker, and Verrecchia, 1991; Carpenter, 2000. Furthermore, corporate default caused by volatile assets
impose a range of costs on managers; for example, the likelihood of forced termination and the loss of labor market capital as well as the value of firm-specific investments Eckbo, Thorburn,
and Wang, 2016. In addition , excess dividend payouts reduce managers’ freedom to use free cash
flows Jensen 1986. Thus, managers are unlikely to support the opportunistic behavior of
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shareholders by increasing asset volatility or dividend payouts, even after the lender reduces monitoring, because those actions hurt their own interests.
We consider whether shareholders offer altered compensation arrangements to managers to overcome their risk aversion and capitalize on the opportunity offered by reduced lender
monitoring. We examine the vega measure of managerial compensation that increases managers’ wealth with stock volatility and is consistent with the call options feature built into shareholders
’ equity investments Guay, 1999; Core and Guay, 2002. We find an economically significant
increase in vega post –CDS inception 39 of its mean value. Total compensation increases in a
statistically significant, but not economically significant, manner 1 of its mean value, indicating that the most significant change occurs in the structure as opposed to the total value of
managerial compensation. [Increase in total compensation, on the one hand, makes managers more
risk averse by magnifying their exposure to their firm ’s risk and, on the other hand, can encourage
managers to take risks Knopf, Nam, and Thornton, 2002; John and John, 1993; Armstrong and Vashishtha, 2012.]
We find that m anagers’ incentives play a pivotal role in the occurrence or prevention of
asset substitution post –CDS inception. The greater the managerial vega, the higher the increases
in RD outlays and the larger the decreases in property, plant, and equipment expenditures. This finding suggests that managers with convex incentives treat the reduced vigilance from lenders as
an opportunity to shift from routine and safe capital investments property, plant, and equipment expenditures to risky investments RD outlays. Similar to investment choices, firms with
higher managerial vega undertake more frequent mergers and acquisitions after CDS inception. Shift of firm resources from relatively safe to risky investment avenues should increase earnings
volatility and bankruptcy risk. We find increases in both factors for firms with higher managerial
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vega following CDS inception. As such, we provide an alternative mechanism for the increased bankruptcy risk following the onset of CDS trading Subrahmanyam, Tang, and Wang, 2014. In
addition, for firms with managerial compensation aligned with shareholder interests, we find increases in excessive dividend payouts, which could enrich shareholders at the sacrifice of
lenders ’ security.
To address the potential endogeneity problems related to CDS inception, particularly the omitted factors that determine the demand and supply of CDS contracts Ashcraft and Santos,
2009, we examine the difference in differences before and after CDS inception relative to non- CDS firms Subrahmanyam, Tang, and Wang, 2014. We use a propensity score matching
approach to pair a control group of non-CDS firms with CDS firms in the year before CDS trade inception Ashcraft and Santos, 2009; Martin and Roychowdhury, 2015. This difference-in-
differences research design helps to isolate the impact of CDS inception relative to other contemporaneous macroeconomic changes. In addition, we use a Heckman two-stage procedure
to control for selection bias Martin and Roychowdhury, 2015. Similar results show that our original findings are less likely to be subject to endogeneity issues. To improve our identification
of reduced lender monitoring, we isolate banks that are likely to have hedged their exposure upon CDS inception Minton, Stulz, and Williamson, 2009. Our results are either stronger or hold only
for the subsample of borrowers associated with such lenders. We make two contributions to the literature. First, by showing changes in borrowers
’ real activities following the CDS inception, we add to the vast literature that examines changes in
lenders’ behavior, borrowers’ accounting policies and cash holdings, and the borrower’s and its supply chain partners
’ financial leverage. Borrowers, on average, pursue more conservative investment policies post CDS inception Subrahmanyam, Tang, and Wang 2017. We, however,
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find that borrowers with high managerial vega undertake more aggressive investment policies. Our results show that shareholders do not always lose upon CDS inception, because of, as indicated in
prior studies, increased threat of foreclosure. Shareholders could benefit from the increased value of call option built into their investments, when managers enhance activities that were previously
constrained by lender monitoring. Results indicate that shareholders offer or managers demand changes in executive compensation contracts upon CDS inception
, which enhance managers’ risk appetite. Hence, our study presents a fuller picture of shifts in the rival lender, shareholder, and
managerial forces that determine firms’ investment and financing policies post–CDS inception.
As such, we respond to the Augustin, Subrahmanyam, Tang, and Wang 2014 call for a thorough examination of changes in corporate policy and stakeholder interests upon CDS inception. Second,
we provide an alternative explanation for the higher bankruptcy risk following CDS trade besides just lender intransigence. The initiation of CDS
trading on a firm’s outstanding debt could be followed by substitution of firm assets from safe to risky ones when managers have high vega
incentives. The resultant increase in operating volatility also increases the bankruptcy risk. Similar to extant empirical papers on the topic of CDS inception, our paper takes a partial
equilibrium approach. We focus on changes in borrower behavior because of reduced lender monitoring upon CDS inception. A general equilibrium study, beyond the scope of one empirical
paper, could determine how CDS inception results in wealth transfer among the involved parties by examining the following conjectures. CDS sellers, who lack any contractual right over the
borrower, should price protect themselves in expectation of reduced lender monitoring. Lenders should then pay a higher price to CDS sellers for their own reduced monitoring. However, lenders
derive other benefits from the purchase of CDS insurance, that is, reduced monitoring costs and lowered reserve requirements, which allows them to expand their loan portfolios while maintaining
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a banking relation with the original borrower. A b orrower’s shareholders could trade off the
increased value of their call options with the increased cost of bankruptcy risk. Finally, managers balance between enhancing their undiversified risks and the additional vega benefits.
The rest of the paper proceeds as follows. Section 2 summarizes the literature and presents the hypotheses. Section 3 describes the sample selection and the measurement of the variables.
Section 4 describes the tests of the hypotheses and Section 5 presents robustness tests. Section 6 presents concluding remarks.
2. Literature review and motivation of hypothesis.
