Credit Default Swaps and Sovereign Debt with Moral Hazard and Debt Renegotiation

This paper studies how a lender's credit insurance activities affect a sovereign borrower in an environment with moral hazard and debt renegotiation. The moral hazard problem arises from the assumption of private information where the lender cannot observe if the sovereign invested or consumed the borrowed funds. We show that insurance serves as a commitment device for the lender. An insured lender has more bargaining power during debt reduction renegotiations and this enables him to extract more from the borrower. Thus, the existence of an insurance market alleviates the moral hazard problem by better aligning the incentives of the lender and the borrower. We also analyze the effect of naked buyers who do not lend directly to the sovereign. Our analysis shows that the market structure of the insurance market matters: if the market is imperfectly competitive, the existence of naked buyers can impede the alleviation of moral hazard.