Shareholder Opportunism in a World of Risky Debt

TABLE OF CONTENTS INTRODUCTION 1152 I. THE ECONOMICS OF CORRELATION-SEEKING 1155 A. How Correlation Determines the Impact of a Contingent Debt 1156 B. The Scale of the Hazard: Contingent Versus Fixed Debt 1163 1. Contingent Debt Not Larger than the Debtor's Equity Value 1165 2. Contingent Debt Big Enough To Cause Bankruptcy 1172 C. Shareholder Opportunism and the Risk-Return Tradeoff 1175 D. The Social Costs of Correlation-Seeking 1180 II. CORRELATION-SEEKING AND THE CRISIS OF 2008 1182 A. Raising Correlation Through Asset Purchases: AIG 1183 B. Beyond the Tipping Point: Fannie Mae and Freddie Mac 1191 III. RECONCEPTUALIZING THE LAW OF CONTINGENT DEBT 1198 A. Federal Financial Regulation After the Crash 1198 1. Correlation Indistinct: The Administration's Regulatory 1198 Vision 2. A Better Approach: Helping Creditors Help Themselves 1203 B. Correlation and Fraudulent Transfer Law 1205 CONCLUSION 1212 INTRODUCTION In 2005, near the peak of the recent housing bubble, derivatives traders at AIG were making money hand-over-fist by selling credit default swaps linked to subprime mortgages. This in itself is not surprising: AIG is an insurance company, and a credit default swap in essence is an insurance policy on a bond or other debt obligation. What is startling is that AIG at the same time was buying up mortgage-backed securities for its own investment portfolio. This meant that the risks borne by the company were correlated: its assets were likely to plunge in value just as deep liability on its swaps was triggered. When the housing market collapsed, the combined damage to both sides of AIG's balance sheet was more than enough to sink the company. This Article explains why seemingly reckless conduct of this type can in fact be fully rational from the perspective of shareholders. Such conduct reflects an opportunism hazard presented by contingent debt, a hazard that is here termed correlation-seeking. If a firm's contingent debts are especially likely to be triggered when the firm is insolvent, the debt contracts transfer value from the firm's unsecured creditors to its shareholders. This transfer creates an incentive for a firm's managers to sell contingent claims against their firm that correlate--or that through asset purchases can be made to correlate--with the firm's insolvency risk. The result is an overuse of contingent debt that produces a variety of social costs such as overinvestment, higher borrowing costs, and possible systemic risk. The potential loss of social wealth is vast given the widespread modern use of contingent debt contracts, which include derivatives such as credit default swaps and options, as well as more traditional arrangements such as loan guarantees. Correlation-seeking is especially pernicious because, unlike other types of shareholder opportunism, it does not force shareholders to bear more risk in order to capture higher returns. To the contrary, equity volatility typically falls when the correlation between the firm's contingent debt risk and insolvency risk rises. Correlation-seeking reduces the volatility of a firm's equity value because it makes it less likely that the firm's contingent debt will be triggered when the equity has any value. This inverse relationship between risk and return marks a stark contrast with asset substitution, a form of shareholder opportunism in which a firm borrows against safe assets but then exchanges them for riskier assets before the debt comes due. Asset substitution makes equity returns more variable, meaning that shareholders must bear more risk to capture higher returns. …