The Rise of the 'Empty Creditor'

One key economic assumption is that people act to preserve their economic interests. Those who have lent money to troubled companies, for example, generally prefer the company remain solvent; otherwise, they can't get paid back. Similarly, lenders to troubled firms frequently favor swift, out-of-court restructuring deals, in which they swap debt for stock, instead of pushing companies into Chapter 11 bankruptcy. That's because companies in Chapter 11 can languish there for years and waste scarce company assets on huge fees to lawyers, consultants, and accountants.

But if a lender or creditor believes it can profit more from a complete failure—i.e., if it has an insurance policy that pays off only in the event of utter devastation—that creditor might be more inclined to push a company toward bankruptcy. And thanks to the financial innovations of recent years—the rampant use of hedging and credit-default swaps, the ability of investors to purchase insurance on debt—that's exactly what seems to be happening. Creditors are acting to protect their economic self-interest by encouraging companies to destroy themselves.

Henry Hu, a professor at the University of Texas law school, been exploring ways in which new players and new financial technologies are warping the traditional behaviors of creditors and owners. He has coined the term empty creditor to describe situations in which people to whom money is owed don't act as if they want to preserve the company that owes them money. For Hu, Exhibit A was the case of Goldman Sachs and the troubled insurer AIG. Goldman, it was reported this spring, was one of the AIG counterparties to whom government money was funneled last fall. AIG posted $2.5 billion in collateral to Goldman under credit-default-swap obligations and made payments of more than $10 billion to the firm to settle credit-default and securities-lending obligations. Hu notes that forcing a troubled company like AIG to pony up billions of dollars in cash as collateral would have been a contributing factor to further erosion of AIG's financial situation, which, in turn, would have rendered many of the financial arrangements Goldman had entered with AIG worthless. But Goldman didn't care that it would wipe out its AIG arrangements, because it had already hedged its exposure to AIG—through contracts, credit-default swaps, or other derivatives. In the words of Goldman's CFO, the firm was "fully protected and didn't have to take a loss." In other words, although Goldman was a significant creditor to AIG, it appeared to have nothing to lose from AIG's demise and potential failure to make good on debt, which is why it was happy to force AIG to disgorge billions of dollars in collateral.

Empty creditors seem to be appearing elsewhere. Take the case of Six Flags, the amusement park operator that is strugging with a huge debt load. Six Flags' management is furiously trying to avoid a Chapter 11 filing. Last week, the company announced an offer to swap about $600 million in debt for about 60 percent of the company's stock. Should bondholders not take up the offer and insist on receiving interest payments, Six Flags said it might have to file for Chapter 11. But as the Washington Post noted in this good article on Six Flags' difficulties, not all bondholders are going along. "Six Flags executives have not publicly identified the holdout, but people with knowledge of the negotiations say that a Fidelity Investments fund owning more than $100 million in bonds due in 2010 has yet to come to the bargaining table." It's unclear why Fidelity isn't coming to the table. It could be because they believe the company might be able to make the interest payments. Or it could be because Fidelity, in this instance, is an empty creditor. The Post notes that one possible explanation for Fidelity's behavior is that "the bondholder has a credit-default swap—essentially an insurance policy—that would pay it a higher sum than an out-of-court agreement." Since credit-default swaps are triggered by formal bankruptcy filings—and not necessarily by out-of-court restructuring deals—bondholders who purchased insurance may feel they have more to gain from a traumatic filing than from an out-of-court settlement. The Financial Times reported last week (subscription required) that the logic of empty creditors may similarly have been a reason why General Growth Properties and paper company Abitibi-Bowater both ended up filing (here and here) for Chapter 11 on April 16.

You can't blame empty creditors for wanting to see companies in which they hold debt go bankrupt. They had the foresight to purchase insurance on their investments. But for all the other people tethered to troubled companies—managers, employees, suppliers, and customers—the presence of empty creditors may make the process of restructuring debt more lengthy and expensive.

© 2009