Equity decoupling refers to the unbundling of the rights and obligations normally associated with shares. Debt decoupling refers to the unbundling of the economic and governance rights normally associated with debt, often through credit derivatives or securitization. Hybrid decoupling involves combined debt and equity positions. All forms appear to be growing in importance. Debt and hybrid decoupling pose risks for debt governance – the relationship between creditors and debtors, including creditors’ exercise of their contractual and legal governance rights. Widespread debt decoupling can also involve externalities and contribute to systemic financial risks.
Debt and Hybrid Decoupling: An Overview
by Henry T.C. Hu and Bernard S. Black
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1084075
[Stavros Peristiani]
Title VII of the Dodd-Frank Act requires that some derivatives contracts be traded on centralized exchanges. While the Act is broadly targeting mostly standardized derivative instruments, the most important derivatives contracts under scrutiny are credit default swaps (CDS). Several policy makers and financial commentators argue that CDS trading amplified risks during the recent financial crisis. In this post, I summarize some findings of my recent New York Fed Staff Report (coauthored with Vanessa Savino) that investigates whether a company with CDS trading on its debt faces a higher default risk.
One important issue that has attracted interest is the behavior of hedged creditors. As Hu and Black (2008) formalize the argument, creditors hedged by swaps are “empty creditors” that may be indifferent to a firm’s survival and, thus, less willing to negotiate a restructuring plan. Indeed, some hedged creditors might actually stand to benefit from a distressed firm’s failure and may prefer a bankruptcy to other resolutions. Bankruptcy costs are generally very onerous, so the interference of an empty creditor may lead to an inefficient economic outcome for other creditors, shareholders, and workers.