Credit Default Swaps and the Empty Creditor Problem

Abstract

Commentators have raised concerns about the empty creditor problem that arises when a debtholder has obtained insurance against default but otherwise retains control rights in and outside bankruptcy. We analyze this problem from an ex-ante and ex-post perspective in a formal model of debt with limited commitment, by comparing contracting outcomes with and without credit default swaps (CDS). We show that CDS, and the empty creditors they give rise to, have important ex-ante commitment benefits: By strengthening creditors' bargaining power they raise the debtor's pledgeable income and help reduce the incidence of strategic default. However, we also show that lenders will over-insure in equilibrium, giving rise to an inefficiently high incidence of costly bankruptcy. We discuss a number of remedies that have been proposed to overcome the inefficiency resulting from excess insurance. One of the most signi…cant changes in the debtor-creditor relationship in the past few years has been the creation and subsequent exponential growth of the market for credit insurance, in particular credit default swaps (CDS). An important aspect of this development is that credit insurance with CDS does not just involve a risk transfer to the insurance seller. It also signi…cantly alters the debtor-creditor relation in the event of …nancial distress, as it partially or fully separates the creditor's control rights from his cash- ‡ow rights. Legal scholars (Hu and Black (2008a,b)) and …nancial analysts (e.g. Yavorsky (2009)) have raised concerns about the possible consequences of such a separation, arguing that CDS may create empty creditors-holders of debt and CDS-who no longer have an interest in the e¢ cient continuation of the debtor, and who may push the debtor into ine¢ cient bankruptcy or liquidation: Patrick Bolton"Even a creditor with zero, rather than negative, economic ownership may want to push a company into bankruptcy, because the bankruptcy …ling will trigger a contractual payo¤ on its credit default swap position.", Hu and Black (2008a), pp.19.We argue in this paper that while a creditor with a CDS contract may indeed be more reluctant to restructure debt of a distressed debtor, it does not necessarily follow that the presence of CDS will inevitably lead to an ine¢ cient outcome. In a situation where the debtor has limited ability to commit to repay his debt, a CDS strengthens the creditor's hand in ex-post debt renegotiation and thus may actually help increase the borrower's debt capacity. The relevant question is thus whether the presence of CDS leads to debt market outcomes in which creditors are excessively tough even after factoring in these ex-ante commitment bene…ts of CDS.In a CDS, the protection seller agrees to make a payment to the protection buyer in the event of a credit event on a prespeci…ed reference asset. In exchange for this promised payment, the protection seller receives a periodic premium payment from the buyer. The credit event may be the bankruptcy …ling of the debtor, non-payment of the d...

Do Empty Creditors Matter? Evidence from Distressed Exchange Offers

“…To account for the endogeneity of the availability of CDS contracts, I use an institutional change in the CDS market as a natural experiment. The findings are consistent with the empty creditor hypothesis of Hu and Black (2008) and Bolton and Oehmke (2011).…”

“…To account for the endogeneity of the availability of CDS contracts, I use an institutional change in the CDS market as a natural experiment. The findings are consistent with the empty creditor hypothesis of Hu and Black (2008) and Bolton and Oehmke (2011).To derive the main testable hypothesis in this paper, I construct a simple theoretical model that includes the key institutional features of a distressed exchange offer. The objective of the model is to establish a link between the amount of CDS insurance purchased by bondholders and the success of a financial restructuring.…”

“…This is why an increase in β leads to a lower amount tendered. This result is analogous to the analysis of the empty creditor problem in Bolton and Oehmke (2011) in the sense that it shows how partly insured bondholders make debt reductions more difficult for a firm.Equation (3) shows in closed form how the bondholder's insurance ratio affects debt reductions, which cannot be determined in the model of Bolton and Oehmke (2011).Unfortunately, it is not easy for an econometrician to observe b. This is because many offers are not pure cash tender offers, but the firm offers a package of new securities.…”

“…This is why an increase in β leads to a lower amount tendered. This result is analogous to the analysis of the empty creditor problem in Bolton and Oehmke (2011) in the sense that it shows how partly insured bondholders make debt reductions more difficult for a firm.…”

“…The objective of the model is to establish a link between the amount of CDS insurance purchased by bondholders and the success of a financial restructuring. While the model builds on Bolton and Oehmke (2011), it differs from their model by linking the CDS insurance ratio to the participation rate in a distressed exchange offer, which is an observable measure for the success of a restructuring. The model predicts a negative relationship between an exogenous change in the insurance ratio of bondholders and the participation rate in a distressed exchange offer.…”