Credit Default Swaps and the Empty Creditor Problem

46 Pages Posted: 4 Jun 2010 Last revised: 20 Mar 2023

See all articles by Patrick Bolton

Patrick Bolton

Imperial College London; 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; Centre for Economic Policy Research (CEPR)

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Date Written: May 2010

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.

Suggested Citation

Bolton, Patrick and Oehmke, Martin, Credit Default Swaps and the Empty Creditor Problem (May 2010). NBER Working Paper No. w15999, Available at SSRN: https://ssrn.com/abstract=1612594

Patrick Bolton (Contact Author)

Imperial College London ( email )

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Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

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European Corporate Governance Institute (ECGI)

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Belgium

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

Martin Oehmke

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

United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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