Impact of naked credit default swaps

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Influence on Default

The obvious way CDS speculation increases the chance of default is through fear.  Traders push up the cost of CDS and the market and businesses alarmingly interprets the high cost as a sign of trouble.

This can cause customers and vendors to lose confidence.  For financial institutions, it can lead to a bank run. More importantly, this fear prevents institutions from rolling over their debt, i.e., issuing new debt to repay maturing ones.  The ability to rollover debt is crucial because in some sense, default is a matter of confidence;  if an institution can always find new creditors, they will always be able to pay existing creditors. 

Aside from perception, naked CDS also drive up the cost of borrowing, according to Yeon-Koo and Sethi.  

If there exist a viable CDS market, the players most optimistic about the ability of the issuers to repay the debt will sell CDS protection instead of purchasing the debt itself.  This takes away natural debt buyers, which in turn drives up the cost of borrowing.  Saddled with more expensive debt, default is thus more likely.

This effect of taking away natural buyers also plays into perception.  If the market thinks the presence of naked CDS will take away potential buyers at debt rollovers, it may charge higher interest in the first place because, as mentioned before, default essentially depends on the ability to rollover debt.

In some cases, institutions are able to meet debt obligations through cash from operations or even through asset sales; they will only rollover debt only if it is financially favorable to do so.   

Thus, by increasing the total amount of money institutions owe, naked CDS make it less likely that institutions can repay debt without borrowing and thus subjects them to more rollover risk.

Influence on Project Selection 

Naked CDS, by taking away natural debt buyers, also impacts how institutions select their projects.

Some projects will not be funded at all because institutions cannot borrow at a reasonable price. 

When institutions manage to borrow the money, naked CDS impact the riskiness of the projects they select. 

If the debt is too high, it may encourage institutions to select a risky project that has a slight chance of generating enough cash to repay the debt in lieu of a safer one that offers no chance of generating enough money.

Conversely, if the debt is high enough so that the adverse outcome of a risky project would not give the institution enough money to repay the debt, the institution may opt for a safer project.

*Eric Dinallo, former Superintendent of Insurance for New York State, puts at it 80 percent.