Credit Default Swaps and the Empty Creditor Problem
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.
For helpful comments we thank Bernard Black, Charles Calomiris, Pierre Collin-Dufresne, Florian Ederer, Mark Garmaise, Charles Jones, Edward Morrison, and seminar participants at Columbia University, Ohio State University, UCLA Anderson, MIT Sloan, Columbia Law School, and the NBER Corporate Finance meetings. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Patrick Bolton & Martin Oehmke, 2011. "Credit Default Swaps and the Empty Creditor Problem," Review of Financial Studies, Society for Financial Studies, vol. 24(8), pages 2617-2655. citation courtesy of