Credit default swaps: Research shows that bankruptcy insurance helps companies increase profits

Controversial to some and widely defended by others, credit default swaps were named by the former president of the U.S. Federal Reserve, Alan Greenspan, as the most important innovation in the financial markets in recent decades. Characterized as a type of insurance that offers protection in the event of bankruptcy or insolvency for companies and governments, CDSs are the subject of a new study by Fundação Getulio Vargas’ Brazilian School of Public and Business Administration (FGV EBAPE), which looked at the impact of this insurance on the growth of organizations. The study analyzed 8,400 companies traded on U.S. stock exchanges between 2000 and 2018, based on quarterly data. The main observation was about cyclicality. Taking the country's GDP growth as a parameter, the researchers analyzed whether companies protected by CDSs experienced different growth in their assets compared to other companies. Using an econometric method, they found that companies covered by CDSs presented 40% lower growth compared to others. Despite this result, the researcher who coordinated the study, Lars Norden, is adamant that credit default swaps are beneficial. Less is more “This study shows that the main effect of CDSs is positive, because even though the companies covered by this type of insurance showed lower growth, this growth was healthier and more stable,” the researcher explains. The study also points out that the “lower growth” of companies covered by CDSs has positive effects on profits and market value, because companies covered by CDSs, simply by considering the risk of bankruptcy, end up eliminating high-risk or unprofitable projects, keeping only the safest and most profitable ones. According to the researcher, this dynamic leads to healthier and more stable growth, helping companies invest in projects that will generate profits. “Our results were found through causal inferences, derived from the econometric method that was used,” he says. In this sense, the researcher emphasizes the importance of this research in assessing the effect of CDSs on the growth and cyclicality of companies. “This study has the potential to impact not only companies, corporate finance and the financial management sector as a whole, but also to help regulate the financial market itself and the international institutions that regulate this market,” he says. To find out more, read the full article here.