Another Reason to Worry About Financial Derivatives

a | A

By Mark Whitehouse

The threat credit derivatives can present to the entire financial system became painfully apparent during the market turmoil of 2008. New research suggests they can also be dangerous for individual companies in normal times.

One of the traditional tenets of finance theory -- and the justification for much of what happens on Wall Street -- is that financial innovation is ultimately good because it completes markets. If financial products allow everyone to take on only the risks they want and slough off those they don't on others, the world economy will work better, and we'll all be richer as a result.

The advent of credit-default swaps, a sort of insurance against defaults by companies, sovereigns and other debtors, plays right into this narrative. By allowing banks and investors to hedge the risk of defaults, the logic goes, they can promote greater diversification, make markets more efficient and even lower the cost of borrowing for people and companies.

The central role that credit derivatives played in the 2008 financial crisis demonstrated that, at the very least, the benefits of the innovation come with a cost. A paper presented yesterday at the annual meeting of the American Economic Association adds an important new element to our understanding of the downside.

The paper's authors -- Marti G. Subrahmanyam of New York University, Dragon Yongjun Tang of the University of Hong Kong and Sarah Qian Wang of the University of Warwick -- looked at the experience of hundreds of companies from 1997 to 2009. They found that after investors started trading credit-default swaps referencing a company's debt, the probability that the company would go bankrupt more than doubled, on average. The more derivative contracts were written on the company's debt, the greater the adverse effect.

The authors see at least two factors that might contribute to the result. First, creditors who have hedged their default risk are less interested in helping a company stay afloat during tough times. Second, the availability of default insurance on a company attracts a larger number of lenders, increasing the complexity of reaching the kind of debt restructuring deals that can keep temporarily troubled companies out of bankruptcy.

It's important to note that the research doesn't necessarily demonstrate that credit-default swaps are, on balance, bad. The detrimental effects on companies' chances of survival, the authors write, must be weighed against potential positives. Increased debt capacity, for example, might allow companies to make desirable investments that otherwise wouldn't happen. And bankruptcies can be useful in eliminating or restructuring unviable companies.

Still, the number of reasons to doubt the inherent desirability of financial innovation is growing.

(Mark Whitehouse is a member of the Bloomberg View editorial board. Follow him on Twitter.)

Read more breaking commentary from Bloomberg View at the Ticker.

-0- Jan/07/2013 14:20 GMT