Do Empty Creditors Matter? Evidence from Distressed Exchange Offers

The empty creditor hypothesis states that debtholders are less willing to agree to a debt restructuring if they are insured with credit default swaps (CDS). However, recent empirical studies measure the success of debt restructurings and find that it is not affected by the availability of CDS contracts. The present paper uses a more precise measure of the success of out-of-court restructurings and shows that credit derivatives have a negative effect on debt reductions. In particular, the average participation rate in U.S. distressed exchange offers is 29 percentage points lower if the firm is a reference entity in the CDS market, compared to an unconditional mean of 54%. To address potential endogeneity problems, the paper uses the introduction of the Big Bang protocol in the CDS market as a natural experiment. A difference-in-differences estimation around the introduction of the protocol confirms the main findings. The results suggest that reference entities in the CDS market find it more difficult to reduce debt out-of-court. This is inefficient in the sense that it can increase the likelihood of future bankruptcy.