Shareholder Opportunism in a World of Risky Debt

This post comes to us from Richard Squire of the Fordham University School of Law.


According to the Treasury Department’s June 2009 report on the financial crisis, the collapse of AIG is Exhibit One in the case for more aggressive federal regulation of derivative contracts. Contrary, however, to the view adopted by Treasury, AIG did not fail merely because it sold credit default swaps linked to subprime mortgages. Rather, it failed because it also bought up mortgage-backed securities for its own investment portfolio. This meant that the risks borne by the company were correlated: its assets were likely to evaporate just as large-scale liability on its swap contracts was triggered. When the housing market collapsed, it was the combined damage to both sides of AIG’s balance sheet that brought down the company.

In a forthcoming article in the Harvard Law Review (available here), I demonstrate that seemingly reckless conduct of this type is in fact fully rational from the perspective of a firm’s shareholders. Such conduct reflects an opportunism hazard created by contingent debt, a hazard I term “correlation-seeking”. If a contingent liability is especially likely to be triggered when the liable firm is insolvent, the contract that creates the liability (such as a credit default swap) transfers expected wealth from the firm’s unsecured creditors to its shareholders. That transfer gives managers an incentive to sell contingent claims against their firm that correlate with the firm’s insolvency risk, even when doing so generates large social costs such as overinvestment and possible systemic risk. The capacity for correlation-seeking to destroy wealth is vast given the widespread current use of contingent debt contracts, which include not only derivatives such as default swaps and options, but also more traditional arrangements such as loan guaranties.

Despite the pervasiveness of the hazard, lawmakers and scholars have overlooked correlation-seeking. As a result, legal rules that aim to prevent opportunism toward creditors regulate contingent liabilities under principles designed for “fixed” liabilities—that is, debts that are certain to come due on a specified future date. Accordingly, contingent debt is treated as less of an opportunism hazard precisely because it is (by definition) less likely than fixed debt to come due. On this view, a contingent liability is like a fixed liability, only less so.

There are several basic problems with this standard view of contingent debt. The first is that, counterintuitively, a contingent liability can cause a much larger opportunistic wealth transfer than will a fixed liability of equal face value. This is because a firm that incurs a $100 fixed liability (such as by taking out a loan) typically receives close to $100 in new assets (the loan proceeds) in exchange. And those new assets mostly neutralize the fixed liability’s dilutive effect on the firm’s unsecured creditors. But when a firm incurs a $100 contingent liability that is, for example, only 10% likely to come due, the firm will receive in exchange new assets worth no more than $10. And, if the contingent liability is especially likely to be triggered when the firm is insolvent, this mismatch between the new assets and the liability’s $100 face value greatly reduces the unsecured creditors’ expected recoveries.

There is a second important reason that contingent liabilities present the larger opportunism hazard. To use fixed liabilities to capture wealth from unsecured creditors, a firm increases its leverage (i.e., it substitutes debt for equity). But higher leverage makes returns on equity more volatile, meaning that shareholders must bear greater risk to capture higher returns. And this same tradeoff is an inescapable feature of asset substitution, a form of shareholder opportunism whereby a firm exchanges low-variance assets for high-variance assets. By contrast, I show that the volatility of equity returns often falls as the correlation between a firm’s contingent liabilities and insolvency risk rises. Correlation-seeking is thus especially pernicious, because it frequently avoids a risk-return tradeoff that tends to make other forms of shareholder opportunism self-limiting.

Finally, a view that conflates fixed and contingent liabilities is problematic because the opportunism mechanisms are different for each. What matters with fixed liabilities is their total face amount relative to the firm’s equity value. The higher this ratio, the greater the degree to which losses are borne by the firm’s creditors. By contrast, a contract that creates a contingent liability with even a relatively large face (or “notional”) value can either benefit or harm a firm’s unsecured creditors, depending on whether the correlation between the contingency and the firm’s insolvency risk is negative or positive. Legal rules that consider only a contingent liability’s face amount, and ignore correlations, will thus produce results almost totally unrelated to the actual opportunism hazard.

The failure by lawmakers to recognize the pivotal role of correlation in the economics of contingent debt is a major shortcoming of traditional creditor protection doctrines such as fraudulent conveyance law. And it also mars the Administration’s proposed Over-the-Counter Derivatives Markets Act of 2009, which similarly takes little account of matters of correlation. Rather, that bill relies on standard measures for preventing overuse of fixed debt, such as higher capital and collateral requirements. Under the Administration’s proposed approach, the costs of using all derivative contracts would rise, but firms could still engage in the type of opportunism that creates the risk of another AIG in the future.

To prevent the high social costs of correlation-seeking, legal rules for contingent debt need to be fundamentally rethought. A powerful first step would be the repeal of the Bankruptcy Code exemptions that now give derivative counterparties priority over an insolvent firm’s other unsecured creditors. Those exemptions undermine the incentive for counterparties to monitor to prevent correlation-seeking, even though their sophistication would make them better monitors than most other creditors. Reform of this type is especially important because the bailouts of large financial institutions have further undermined creditor monitoring incentives by shifting the consequences of correlation-seeking onto another group of unsecured “creditors”: U.S. taxpayers. To the extent market participants perceive that a precedent has been set for more bailouts in the future, correlation-seeking is a bigger hazard than ever.

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