Empty Creditors: How Goldman’s $7 billion was ‘not material.’
It is great when the Journal publishes substantive articles about how a lack of market design can have detrimental consequences for market functioning. Take this one from last Friday’s paper. The author, law professor Henry Hu at the Univ. of Texas, reminds us that a bond is a contract with several discrete components that up until recently has been a conceptual as well as a practical whole. No longer.
“What is an empty creditor? Consider that debt ownership conveys a package of economic rights (to receive principal and interest), contractual control rights (to enforce the terms of the agreement), and other legal rights (to participate in bankruptcy proceedings). Traditionally, law and business practice assume these components are bundled together. Another foundational assumption: Creditors generally want to keep solvent firms out of bankruptcy and to maximize their value.”
In other words, in addition to the right to collect payments bond holders also have a meta-right, if you will. They have the right to enforce the terms of contract itself. Most of us have heard about the huge notional value of CDS outstanding and the current efforts underway to establish a CDS clearinghouse so that firms are immunized from counterparty risk and debacles like AIG are not as likely (a side note: what is being discussed is only centralized clearing of CDS, not centralized trading, as on a listed stock, bond or derivatives exchange). Ownership of CDS is like owning a put on a company’s bonds or other debt obligations. If the bonds default, a CDS holder can hit up the CDS writer for the defaulted value.
So far, so good but here’s the deal: what if a company has $10 billion of corporate bonds outstanding but there are $20, $50 or $100 billion of CDS outstanding? That’s perfectly legal today. You don’t have to own the bonds to buy a put option on them. In insurance lingo, you don’t have to have an insured interest to own the CDS. That’s kind of like buying a life insurance policy on your clumsy neighbor down the street. He may well fall out of a tree and kill himself trying to trim it, but now you have an incentive to see that happen. His wife and kids, the normal beneficiaries of a life insurance contract, most often do not have that incentive.
What we’ve discovered is that institutions like Goldman can have no material economic exposure to a company like AIG because they have found a way to hedge that risk. But through the ownership of CDS they can have a very significant residual contractual leverage on the company’s capital structure and hence its future. I don’t think our major economic or financial theorists foresaw this possibility until it was upon us a few years ago. Should multiples of CDS be allowed to exist vs. the amount of underlying bonds?
