Credit Default Swaps and the Empty Creditor Problem

Review of Financial Studies (2011), 24(8): 2617-2655

59 Pages Posted: 13 Mar 2010 Last revised: 10 Dec 2015

Patrick Bolton

Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Martin Oehmke

London School of Economics & Political Science (LSE) - Department of Finance; Columbia Business School - Finance and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: January 4, 2011

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.

JEL Classification: G32, G33, G22

Suggested Citation

Bolton, Patrick and Oehmke, Martin, Credit Default Swaps and the Empty Creditor Problem (January 4, 2011). Review of Financial Studies (2011), 24(8): 2617-2655. Available at SSRN: https://ssrn.com/abstract=1570165 or http://dx.doi.org/10.2139/ssrn.1570165

Patrick Bolton

Columbia Business School - Department of Economics ( email )

420 West 118th Street
New York, NY 10027
United States

HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Martin Oehmke (Contact Author)

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

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