A significant amount of ink has been spilled in recent months over the state of the financial derivatives markets and their role in 2008’s financial melt-down.
Some of that ink has spilled into the area of corporate insolvency¬†– and in particular, into an examination of whether or not credit default swaps (CDSs)¬†– a type of derivative instrument designed to let a creditor hedge¬†its¬†risk with a debtor – have any impact on the dynamics of work-out negotiations when the debtor experiences difficulty repaying the debt.
This blog has devoted two prior posts (here and here) to the role of¬†CDSs and bankruptcy.¬† One of the troubling issues raised by researchers (and noted here) in connection with the distressed debt market has been whether or not high-risk investors (i.e., speculators) might be incentivized to buy CDSs on distressed debt, banking on the debtor’s default (akin to “naked short selling” of a company’s stock) on the anticipation that the debtor would fail – thereby triggering a payout on the CDS.¬† This issue is known more popularly as the “empty creditor problem” – so-called because speculators holding the CDSs issued with respct to a distressed company are not legitimate creditors, but merely risk-takers maneuvering to profit from (and thereby attempting to engineer) corporate failure.
As 2009 draws to a close, the International Swaps and Derivatives Association (ISDA) has stepped into the debate with a recently published research paper on the matter.¬† Entitled “The Empty Creditor Hypothesis,” the ISDA’s research paper argues – convincingly – that this sort of speculation is far less a problem than some have suggested.¬† This is so primarily because the pricing on CDSs begins to rise dramatically as the CDS-backed debtor begins to falter.¬† Therefore, the profits to be made from purchasing such CDSs are, effectively, non-existent – and there is little reason to speculate in them.
The ISDA’s point is that there simply isn’t enough of a profit to be made in purchasing CDSs typically issued on distressed firms – and therefore, insufficient potential payoff to attract the sort of “empty creditors” that have concerned distressed debt researchers.¬† As a result, the “empty creditor problem” really isn’t a “problem.”
But speculation isn’t the only point of impact that CDSs may have on a distressed debtor’s efforts to negotiate with creditors.¬† Where the holder of a CDS is also the original lender or the holder of CDS-backed debt, the existence of such derivative securities – which effectively “back-stop” the underlying debt similar to the way in which a fire¬†insurance policy “back-stops” the risk of loss on a building – may incentivize the company’s creditors to be far less flexibile in¬†their discussions with the debtor.
The ISDA attempts to address this potential effect by pointing to a small sample of data available for the research paper, which suggests that during the period that CDS hedging has been available,¬†workouts (i.e., restructuring events) have grown as a percentage of the number of defaults recorded during the same period.¬† Therefore, “the . . . statistics presented . . . would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”¬† However, the ISDA admits that
“[a] full analysis of the relationship between [the] likelihood of restructuring and availability of hedging with credit default swaps would require extensive data collection, . . . and is beyond the scope of this note.”
The ISDA’s suggestion that CDSs have essentially no impact on corporate restructuring smacks of whistling by the graveyard: In fact, the impact of CDSs has been noted, at least¬†anecdotally, in several large corporate bankruptcy filings during 2008 and 2009.¬† Nevertheless, the precise nature and extent of the “CDS effect” remains to be seen – and is likely fodder for another research paper . . . or five.