ISDA research note gives little credence to empty creditor hypothesis

By Angela McDaniels

Tacoma, Wash., Dec. 17 - The "empty creditor" hypothesis is not consistent with the way credit default swaps work or with observed behavior in debt markets, according to International Swaps and Derivatives Association, Inc. head of research David Mengle.

The empty creditor hypothesis relates to the effect of hedging credit risk on the behavior of creditors of distressed institutions. ISDA published an analysis of the issues and implications raised by the hypothesis in a research note authored by Mengle on Thursday.

According to ISDA, the hypothesis posits that creditors who hedge their exposures using CDSs are indifferent to a firm's survival. Others have extended the hypothesis to suggest hedged creditors might benefit from a distressed firm's failure and prefer that such firms file for bankruptcy rather than engage in a work-out while remaining solvent.

"The empty creditor hypothesis has generated significant interest in the press and among legal practitioners," Mengle said in an ISDA news release.

"Because it could influence future regulatory policy, it is important to analyze both the logic and the evidence in support of and against it."

The research note states that although hedging might affect behavior because it changes one's risk exposure, it also involves a foregone opportunity to maximize the upside of an investment. Mengle concludes that only if such hedging could lead to systematic opportunities that might distort economic behavior or the functioning of legal institutions should it be treated as a cause for concern.

The note segments the hypothesis into three specific and operational hypotheses:

• Exercise of contractual rights prior to bankruptcy. The hypothesis implies that hedged creditors are less likely to approve an out-of-court restructuring than unhedged creditors.

The note said that if the ability to hedge using CDSs tends to make restructurings less likely than when the hedge was not available, the number of restructurings as a percentage of credit defaults should be lower when CDSs are available than when they are not.

The data shows this figure at about 9% over the entire sample period from 1984 to 2009, according to ISDA. But ISDA said that restricting the data to the period of liquid CDS markets from 2003, restructurings as a percentage of credit defaults jumps to 90%, which does not support the hypothesis;

• Exercise of legal rights within bankruptcy. According to the hypothesis, hedged creditors are indifferent to the value of the firm after bankruptcy, which leads to inefficient decisions on restructuring versus liquidation.

In Mengle's view, this hypothesis seems implausible. After settlement of CDS contracts, hedged creditors have been compensated for their losses and have the choice of either selling the defaulted bonds at the current price or retaining the bonds and engaging in the bankruptcy process. He said that rational bondholders in this case have incentives to maximize recovery values; and

• Negative economic ownership. The hypothesis implies that prior to bankruptcy, hedged creditors will not only be indifferent to the value of the distressed firm, but might even benefit from failure by building up CDS hedges for which the face amount exceeds the face amount owned.

The note states that it is not possible to determine from available data whether overhedging is a significant activity, or indeed if it occurs at all. But Mengle presents examples that show the strategy generating high expenses and low returns, "from which it is reasonable to question the plausibility of this hypothesis."

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