Reno Hayek Symposium

Henry T.C. Hu coined the term “empty creditor” a few years ago. In short, it is the use of credit default swaps (CDS) to separate economic risk of investments from the legal rights inherent in those investments. CDS are those derivatives which act as insurance against debtor default or downgrade. A creditor or investor holding obligations of a debtor can reduce or eliminate the economic risk of that investment by buying a CDS. In doing that, however, the creditor does not relinquish his legal rights to enforce the debt obligation, to participate in and even control bankruptcy proceedings.

As Hu points out in the 4/10/2009 edition of the Wall Street Journal, there is nothing wrong with this risk hedging, this insurance; it is the exercise of freedom of contract. It does point up a change in the alignment of interests (economic and legal) which form the basis of our legal, financial and regulatory systems. Apparently, the suretyship doctrine of subrogation, where the guarantor “stands in the shoes of” and succeeds to the rights of the guarantee, does not apply to CDS. If subrogation did apply to CDS, the economic and legal interests would be properly aligned.

Hu suggests that the empty creditor phenomenon may explain Goldman’s claim that its $7 Billion of exposure to AIG was immaterial. Goldman had hedged its economic risk with CDS. His first-step,  low-cost regulatory solution is a CDS clearinghouse. Progress on this idea had already started in the industry before the real estate bubble burst. While the clearinghouse concept is necessary it is best accomplished by industry associations not the government.

I suggest that the real solution is to make subrogation follow the CDS exercise. When the swap issuer pays on the contract he becomes entitled to all creditor rights to the full extent of his payment.

Hu highlights a problem that is a subtle one, to date overlooked it seems; but it is important nonetheless. His article in the WSJ is a good one, well worth the read.

Tom Motherway