The "Empty Creditor"

Henry Hu, a professor at the University of Texas Law School, wrote a very interesting editorial in the Wall Street Journal on Friday concerning what he terms "empty creditors."

Such creditors, according to Mr. Hu's description,

"Thus the "empty creditor": someone (or institution) who may have the contractual control but, by simultaneously holding credit default swaps, little or no economic exposure if the debt goes bad. Indeed, if a creditor holds enough credit default swaps, he may simultaneously have control rights and incentives to cause the debtor firm's value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court."

It's the sort of convoluted situation that the writers of our bankruptcy laws never imagined.

In the case of AIG and Goldman, which Mr. Hu uses to illustrate his point, the latter avoided a $7B loss, rather than, say, made an actual gain. But, as I observed to my business partner, on a relative basis, that's still a $7B gain over their original, unhedged position.

Imagine if a firm went further, and bought protective swaps beyond the value of their exposure, thus giving them a bona fide incentive for their counterparty's dissolution.

Mr. Hu's point is that there should be some acknowledgement of this problem, and some sort of safeguard to avoid allowing a counterparty to undermine legitimate bankruptcy proceedings.

Hu's own suggestions are rather lame- a "real-time informational clearinghouse for credit default swaps...." Highly unlikely. Those firms trading in this market are not interested in divulging their positions.

What would make more sense would be a modification of bankruptcy law such that any creditor found to be an "empty creditor," per Mr. Hu's description, would be removed from the pool of truly at-risk creditors, so that their lack of consent to a bankruptcy plan would not hinder its acceptance.

It seems to be a genuine problem, with the current concentration in commercial banking. Actions by a counterparty to a weak bank can trigger a rise in value of the credit default swaps of that bank, thus giving the counterparty a an interest in the bank's failure. This is probably not behavior which we, as a society, wish to reward.