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Credit Default Swaps and the Empty Creditor Problem

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  • Patrick Bolton
  • Martin Oehmke

Abstract

The empty creditor problem 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 insurance through 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. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhr002
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Bibliographic Info

Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 24 (2011)
Issue (Month): 8 ()
Pages: 2617-2655

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Handle: RePEc:oup:rfinst:v:24:y:2011:i:8:p:2617-2655

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Cited by:
  1. Ana Fostel & John Geanakoplos, 2011. "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," Cowles Foundation Discussion Papers 1809, Cowles Foundation for Research in Economics, Yale University.
  2. Mikhail Chernov & Alexander S.Gorbenko & Igor Makarov, 2011. "CDS Auctions," FMG Discussion Papers dp688, Financial Markets Group.
  3. Stefan Arping, 2012. "Credit Protection and Lending Relationships," Tinbergen Institute Discussion Papers 12-142/IV/DSF48, Tinbergen Institute.
  4. Patrick Augustin, 2012. "Sovereign Credit Default Swap Premia," Working Papers 12-10, New York University, Leonard N. Stern School of Business, Department of Economics.

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