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Credit Default Swaps and the Empty Creditor Problem

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  • Patrick Bolton
  • Martin Oehmke

Abstract

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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15999.

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Date of creation: May 2010
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Handle: RePEc:nbr:nberwo:15999

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Cited by:
  1. Stefan Arping, 2012. "Credit Protection and Lending Relationships," Tinbergen Institute Discussion Papers 12-142/IV/DSF48, Tinbergen Institute.
  2. Patrick Augustin, 2012. "Sovereign Credit Default Swap Premia," Working Papers 12-10, New York University, Leonard N. Stern School of Business, Department of Economics.
  3. Arping, Stefan, 2014. "Credit protection and lending relationships," Journal of Financial Stability, Elsevier, vol. 10(C), pages 7-19.
  4. : Gi H. Kim, 2013. "Credit Default Swaps, Strategic Default, and the Cost of Corporate Debt," Working Papers wpn13-12, Warwick Business School, Finance Group.
  5. Markose, Sheri & Giansante, Simone & Shaghaghi, Ali Rais, 2012. "‘Too interconnected to fail’ financial network of US CDS market: Topological fragility and systemic risk," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 627-646.
  6. Mikhail Chernov & Alexander S.Gorbenko & Igor Makarov, 2011. "CDS Auctions," FMG Discussion Papers dp688, Financial Markets Group.
  7. : Haitao Li & Gi H. Kim & Weina Zhang, 2010. "The CDS-Bond Basis and the Cross Section of Corporate Bond Returns," Working Papers wpn10-03, Warwick Business School, Finance Group.
  8. Andras Danis, 2013. "Do Empty Creditors Matter? Evidence from Distressed Exchange Offers," IEHAS Discussion Papers 1334, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
  9. Ana Fostel & John Geanakoplos, 2011. "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," Levine's Working Paper Archive 786969000000000168, David K. Levine.
  10. repec:dgr:uvatin:2013032 is not listed on IDEAS
  11. Jaewon Choi & Or Shachar, 2013. "Did liquidity providers become liquidity seekers?," Staff Reports 650, Federal Reserve Bank of New York.
  12. Campello, Murillo & Matta, Rafael, 2012. "Credit default swaps and risk-shifting," Economics Letters, Elsevier, vol. 117(3), pages 639-641.
  13. Parlour, Christine A. & Winton, Andrew, 2013. "Laying off credit risk: Loan sales versus credit default swaps," Journal of Financial Economics, Elsevier, vol. 107(1), pages 25-45.
  14. : Haitao Li & Weina Zhang & Gi H. Kim, 2011. "The CDS-Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns," Working Papers wpn11-04, Warwick Business School, Finance Group.
  15. repec:dgr:uvatin:2012142 is not listed on IDEAS
  16. Bolton, Patrick & Oehmke, Martin, 2013. "Strategic conduct in credit derivative markets," International Journal of Industrial Organization, Elsevier, vol. 31(5), pages 652-658.
  17. Batchimeg Sambalaibat, 2012. "Credit Default Swaps and Sovereign Debt with Moral Hazard and Debt Renegotiation," 2012 Meeting Papers 1093, Society for Economic Dynamics.

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