Credit Default Swaps and the Empty Creditor Problem

Patrick Bolton is a Professor of Finance and Economics at Columbia University.

In the paper, Credit Default Swaps and the Empty Creditor Problem, which was recently made publicly available on SSRN, my co-author, Martin Oehmke of Columbia University, and I propose a limited commitment model of credit default swaps.

While many commentators have raised concerns about the ex-post inefficiency of the empty-creditor problem that arises when a debt-holder has obtained insurance against default but otherwise retains control rights, our analysis shows that credit default swaps add value by acting as a commitment device for borrowers to pay out cash. Hence, CDS have important ex-ante commitment benefits. Specifically, they increase investment and, by eliminating strategic default, can make existing projects more efficient. However, we also show that when creditors are free to choose their level of credit protection, they will generally over-insure, resulting in an empty creditor problem that is inefficient ex-post and ex-ante. This over-insurance occurs even when CDS markets perfectly anticipate the inefficient behavior of empty creditors, and leads to excessive incidence of bankruptcy and too little renegotiation with creditors relative to first best.

Our analysis leads to a more nuanced view on policy than most of the existing law and economics literature. In particular, any policy response to inefficiencies arising from the empty creditor problem should be mindful of the beneficial commitment role of CDS. Eliminating empty creditors altogether, for example by stripping protected creditors of their voting rights or by making restructuring a credit event, would be over-inclusive according to our analysis. A more fruitful approach might be to cap enforceable CDS payments or make CDS positions subject to approval by both the debtor and the creditor. Moreover, disclosure of CDS positions may help alleviate the problem by allowing debtors and creditors to contract on CDS positions taken by creditors.

The full paper is available for download here.

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