Recent research co-authored by three faculty from the Lally School of Management at Rensselaer Polytechnic Institute revealed that credit default swap contracts affect the dynamic of the lender-creditor relationship in the financial industry.

Credit default swaps (CDS) are a common tool that allows an entity such as a bank or other financial intermediaries to buy credit protection on debt contracts. Similar to an insurance policy, a lender pays a premium for a CDS contract so that in the event a creditor defaults, the lender is made whole on the loan through the CDS rather than from the creditor.

Using loan-level data spanning 11 years, assistant professors Thomas Shohfi and Brian J. Clark and professor Bill B. Francis from Rensselaer, along with co-author and Rensselaer doctoral graduate James Donato from the University of Wisconsin River Falls, found that when CDS trading is initiated on a firm’s debt, there is a decrease in interactions between the original creditor and lender, leading to a lower probability of refinancing.

“The lender, knowing he has little to no risk of losing the investment, has few incentives to work with the creditor when default risk in bankruptcy is hedged via CDSs,” Shohfi said.

These findings hold a potential impact in the current economic crisis caused by the COVID-19 pandemic. Since the beginning of the global shutdown, major companies like Hertz, Virgin Atlantic, Lord and Taylor, Neiman Marcus, and J.C. Penney have filed for bankruptcy. The research indicates that if their debt is backed by the multi-trillion-dollar CDS contract industry, banks would be less likely to try to work out a repayment solution.

“Our research shows that when a company has trouble satisfying their debt servicing and falls into bankruptcy,” Shohfi said, “it is likely that nonbank entities like private equity firms that hold the CDS contracts are going to be more involved in how these companies come through debt issuance.”

The analysis was published in the Journal of Banking & Finance.