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    The “Empty Creditor Hypothesis” – Systemic Financial Risk? Or Worrisome Empty-Headedness?

    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 research paper has received attention – and succinct summaries – from the New York Times, London’s Financial Times, and Reuters.

    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.

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