Optimal Financing with CDS Markets

One could argue that CDSs improve risk sharing, hence credit supply and financing terms for firms. Accordingly, one would expect risky borrowers to benefit the most from CDS insurance. This is in contrast, however, with recent empirical evidence (Ashcraft and Santos (2009) and Hirtle (2009)). This paper develops a model examining optimal financing policies in the presence of CDSs when competitive lenders have different exposures to borrowers' risk. The model shows that the existence of CDSs benefits safe borrowers and harms risky ones. Following financing, the probability of a "credit event" (default following borrowers' failure to renegotiate out-of-court) is determined endogenously in a global-game setup with heterogenous payoffs. Lenders with greater risk exposure contribute to a higher probability of default and lenders that receive a higher weight in the financing process are more influential in determining renegotiation outcomes. Prior to financing, lenders with higher risk exposure benefit the most from CDS insurance and allow for reduced re-payments - increasing borrowers' surplus in the absence of distress. Riskier (safer) borrowers finance more heavily with lenders that have lower (higher) exposure; lenders, in turn, insure less (more) often and the probability of default given distress is lower (higher). The model sheds light on the liquidity of CDSs across risk-differentiated borrowers and allows for proposals that improve the welfare of market participants.