by on April 7, 2010 at 7:15 am in Economics, Law | Permalink

Richard Squire has an important new paper in the Harvard Law Review:

…This Article identifies a pervasive opportunism hazard created by
contingent debt that lawmakers and scholars have overlooked. If liability on a firm’s
contingent debt is especially likely to be triggered when the firm is insolvent, the
contract that creates the debt transfers wealth from the firm’s creditors to its
shareholders. A firm therefore has incentive to engage in correlation-seeking – that is,
to incur contingent debts that correlate, or that through asset purchases can be made to
correlate, with the firm’s insolvency risk. The consequence is an overuse of contingent
debt that destroys social wealth through overinvestment, higher borrowing costs,
financial distress, and potential systemic risk. Correlation-seeking is especially
pernicious because, unlike other forms of shareholder opportunism such as asset
substitution, it can reduce risk to shareholders even as it increases shareholder returns.

It's long been known that a firm close to bankruptcy has an
incentive to gamble because if the gamble pays off the
shareholders prosper and if the gamble fails then the shareholders are no worse off (since the firm was already close to bankruptcy). 
But gambles like this
add to shareholder value primarily by transferring wealth from
the creditors who bear the downside risk without any hope of upside gain.

Squire shows how this idea is magnified when we add
contingent debt and correlated asset returns.  A contingent debt is one that must
be paid only in certain states.  If the shareholders take on
contingent debt and at the same time buy assets with low or negative
payoffs in the same set of states then the shareholders can focus the downside risk into the states in which they are bankrupt anyway – thus focusing the downside risk onto unsecured creditors. 

Correlation seeking of this kind becomes easier with contingent
securities and more difficult to monitor.  As Squire points out even as AIG was writing credit default
swaps (a type of contingent debt) on MBS it was buying MBS for its own portfolio and of course the ultimate unsecured creditors, the taxpayers, paid the price. 

1 E. Barandiaran April 7, 2010 at 8:51 am

Alex, although Squire and you are talking about debt strategies of private companies, it’s my impression that your ideas look as if they were inspired by governments’ debt strategies that are usually discussed as time-inconsistent strategies that trigger fiscal crises. Indeed, the size of government and the lack of effective control of government borrowing in most democracies (look at what is going on in your country) imply that those strategies have a much larger impact on the economy than when undertaken by private companies.
BTW: It’s also my impression that not enough attention is being paid to government’s heavy reliance on deceptive accounting and counting practices.

2 Richard Squire April 7, 2010 at 12:14 pm

@ mark:

I agree that managerial risk-aversion cuts against the traditional thesis that firms are more likely to take on risky projects when they’re on the brink of insolvency. But that’s one way that correlation-seeking is different: it is in the interests of shareholders even when the firm is fully solvent. Moreover, correlation-seeking tends to decrease risk (as measured by equity volatility) because it reduces the chances that the firm’s contingent liabilities will be triggered in a situation when the firm is otherwise solvent. Thus, we should tend to see this kind of conduct in “good times,” just as the AIG story reveals (and your own comment predicts).

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4 mbt cheap April 14, 2010 at 4:45 am

I guess I could actually read the law review article…. I bet these issues are addressed. But that would take too long!

5 polo shirts November 23, 2010 at 10:13 pm

it seems that there might be agency issues. Ultimately, it seems like the focus should be on the incentives of the choosers

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