Lane Hickenbottom/ReutersProfit growth at Berkshire Hathaway, run by Warren E. Buffett, was aided by derivatives.Last week we learned that one of the biggest critics of derivatives – Warren E. Buffett – actually made a lot of money from them.
This is kind of indicative of the general reality: no matter how much has changed with regard to derivatives after the enactment of Dodd-Frank, much remains the same.
Take, for example, the issue of credit-default swaps and financial distress. Before the financial crisis, bankruptcy scholars, including myself and others, noticed that the growth of these swaps had the potential to change the way restructurings were conducted.
While it is normally assumed that creditors are interested in keeping a solvent but financially distressed company out of bankruptcy and are therefore willing to renegotiate out of court, a hedged creditor may lack the incentive to participate in an out-of-court workout.
In extreme cases, creditors might have incentives to thwart workouts and file involuntary bankruptcy cases, all with an eye toward activating their default swap contracts. This problem could be especially extreme in North America, where, for historical reasons, “restructuring” is often not included as a credit event in standard default swap contracts.
It is also possible that the holder of a large, speculative swap position could acquire a position in a distressed firm’s traded debt to block a potential workout. After the onset of financial distress, it could be that the cost of such a blocking position on the distressed debt market would be justified given a sufficiently large credit-default swap position.
Indeed, if the market for credit-default swaps is made up mostly of speculators, as seems likely, the above situation, or something like it, might be the most plausible. After all, it is unclear how many buyers of credit-default swaps actually use them to hedge ordinary bonds.
This is part of the phenomenon called the “empty creditor” problem by Professors Henry T.C. Hu and Bernard S. Black.
Dodd-Frank did not even attempt to address this issue, so how might be that be accomplished?
In a paper to appear in the Journal of Applied Corporate Finance, co-written with Rajesh P. Narayanan of Louisiana State University, I argue that one good starting point might be the Williams Act.
In particular, the Williams Act requires shareholders to disclose large (5 percent or more) equity positions in companies.
Perhaps holders of default swap positions should face a similar requirement. Namely, when a triggering event occurs, a holder of swap contracts with a notional value beyond 5 percent of the reference entity’s outstanding public debt would have to disclose their entire credit-default swap position.
In the paper, Mr. Narayanan and I suggest that such a disclosure obligation could kick in at the onset of financial distress, when it becomes most useful to understand the incentives of parties to workout negotiations. One clear indicator of financial distress that could be used is the issuance of a going concern qualification by the firm’s auditors.
To our minds, this represents one workable solution to the challenges that credit-default swap contracts create for resolution of financial distress.