In this Article, we begin what we believe will be a fruitful area of scholarly inquiry: an in-depth analysis of credit derivatives. We survey the benefits and risks of credit derivatives, particularly as the use of these instruments affect the role of banks and other creditors in corporate governance. We also hope to create a framework for a more general scholarly discussion of credit derivatives.
We define credit derivatives as financial instruments whose payoffs are linked in some way to a change in credit quality of an issuer or issuers. Our research suggests that there are two major categories of credit derivative. First, a credit default swap is a private contract in which private parties bet on a debt issuer’s bankruptcy, default, or restructuring. For example, a bank that has loaned $10 million to a company might enter into a $10 million credit default swap with a third party for hedging purposes. If the company defaults on its debt, the bank will lose money on the loan, but make money on the swap; conversely, if the company does not default, the bank will make a payment to the third party, reducing its profits on the loan.
Second, a collateralized debt obligation (CDO) is a pool of debt contracts housed within a special purpose entity (SPE) whose capital structure is sliced and resold based on differences in credit quality. In a “cash flow” CDO, the SPE purchases a portfolio of outstanding debt issued by a range of companies, and finances its purchase by issuing its own financial instruments, including primarily debt but also equity. In a “synthetic” CDO, the SPE does not purchase actual bonds, but instead enters into several credit default swaps with a third party, to create synthetic exposure to the outstanding debt issued by a range of companies. The SPE finances its purchase by issuing financial instruments to investors, but these instruments are backed by credit default swaps rather than any actual bonds.
In the Article’s first substantive part, we discuss the benefits associated with both types of credit derivatives, which include increased opportunities for hedging, increased liquidity, reduced transaction costs, and a deeper and potentially more efficient market for trading credit risk. We then discuss the risks associated with credit derivatives, such as moral hazard and other incentive problems, limited disclosure, potential systemic risk, high transaction costs, and the mispricing of credit. After considering the benefits and risks, we discuss some of the implications of our findings, and make some preliminary recommendations. In particular, we focus on the issues of disclosure, regulatory licenses associated with credit ratings, and the special treatment of derivatives in bankruptcy.
