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«Richard Squire TABLE OF CONTENTS INTRODUCTION I. THE ECONOMICS OF CORRELATION-SEEKING A. How Correlation Determines the Impact of a Contingent Debt ...»

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Richard Squire




A. How Correlation Determines the Impact of a Contingent Debt

B. The Scale of the Hazard: Contingent Versus Fixed Debt

1. Contingent Debt Not Larger than the Debtor’s Equity Value

2. Contingent Debt Big Enough To Cause Bankruptcy

C. Shareholder Opportunism and the Risk-Return Tradeoff

D. The Social Costs of Correlation-Seeking


A. Raising Correlation Through Asset Purchases: AIG

B. Beyond the Tipping Point: Fannie Mae and Freddie Mac


A. Federal Financial Regulation After the Crash

1. Correlation Indistinct: The Administration’s Regulatory Vision

2. A Better Approach: Helping Creditors Help Themselves

B. Correlation and Fraudulent Transfer Law




Richard Squire∗ Modern finance is increasingly dominated by derivatives and similar contracts that create contingent debts, which become payable only upon the occurrence of an uncertain future event. 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 purchasescan 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.

Conduct that is consistent with correlation-seeking played a central role in the 2008 financial crisis, causing the deep losses suffered by the three firms to receive the biggest bailouts: AIG, Fannie Mae, and Freddie Mac. Yet current and proposed legal rules for derivatives and other contingent debt contracts ignore matters of correlation, increasing the risk of another financial crash in the future.


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 ––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––– * Associate Professor, Fordham Law School. For helpful comments and conversations, I am grateful to Michele Destefano Beardslee, Margaret Blair, Susan Block-Lieb, Emily L. Cauble, Elizabeth F. Emens, Jill E. Fisch, George S. Geis, Sean J. Griffith, Jesse Grunfeld, Henry Hansmann, Rich Hynes, Stacey Iris, Robert J. Jackson, Jr., Jody S. Kraus, Paul G. Mahoney, Edward R. Morrison, Richard A. Posner, Larry E. Ribstein, Amanda M. Rose, Josh Singer, Steve Thel, Randall S. Thomas, and Ben Walther. Sue Zhou provided excellent research assistance. Any errors are my own.

2010] SHAREHOLDER OPPORTUNISM 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. And the same is true when a firm transfers value from its creditors to its shareholders by increasing its ratio of debt to equity, or its “leverage.” Correlationseeking thus avoids a risk-return tradeoff that tends to make other forms of shareholder opportunism self-limiting.

Conduct that is consistent with correlation-seeking played a key role in the 2008 financial crisis. Such conduct is evident not only in the pre-crisis years at AIG, but also at the government-sponsored mortgage companies Fannie Mae and Freddie Mac. Both Fannie and Freddie incurred deep contingent debts, in the form of guarantees on mortgage assets, that were highly likely to be triggered en masse under conditions when their shareholders would already be wiped out. Conventional accounts attribute risk-taking in these three firms to mere recklessness, or to schemes by managers to expropriate wealth from shareholders. But the fact that the companies incurred correlated asset and contingent debt risks suggests that their managers instead were trying to enrich shareholders at the expense of creditors — or, as it turned out, taxpayers. Although the correlated risks ultimately materialized, driving the firms insolvent, it does not follow that the managers’ decisions were contrary to shareholder interests at the time they 1154 HARVARD LAW REVIEW [Vol. 123:1151 were made. But those decisions did ensure that insolvency, if it came, would be severe, which is why AIG, Fannie Mae, and Freddie Mac were the three firms that received by far the biggest bailouts.

Despite the potential scope of the correlation-seeking hazard, neither lawmakers nor commentators have recognized the central role of correlation in the economics of contingent debt. Legal doctrines meant to protect creditors rely instead on principles designed for “fixed” debt — a term used here to mean debt that is certain to come due on a specified future date. Accordingly, a contingent debt is treated as less of an opportunism hazard because it is (by definition) less likely than a fixed debt to come due. On this view, a contingent debt is like a fixed debt, only less so.

There are at least two basic problems with this standard view of contingent debt. The first is that, counterintuitively, a contingent debt contract can capture significantly more wealth from a firm’s unsecured creditors than would a fixed debt contract with the same face value.

This is because a firm that incurs a $100 fixed debt (such as by taking out a simple loan) typically receives close to $100 in new assets (the loan proceeds) in exchange. And those new assets mostly neutralize the debt’s dilutive effect on the firm’s unsecured creditors. But when a firm incurs a $100 debt that has, for example, only a 10% chance of coming due, the firm receives in exchange new assets worth no more than $10. And if this contingent debt is especially likely to be triggered when the firm is insolvent, the disparity between the new assets and the debt’s $100 face value greatly reduces expected creditor recoveries.

A second problem with legal doctrines that fail to distinguish between fixed and contingent debt is that the opportunism mechanisms are different for each. What matters most with fixed debt is its total face value relative to the firm’s equity value: the higher this ratio, the greater the degree to which losses are borne by the firm’s creditors rather than its shareholders. By contrast, a contract that creates a contingent debt with even a relatively large face value (or, in the language of derivatives, “notional” amount) can either benefit or harm a firm’s unsecured creditors, depending on whether the correlation between the contingency risk and the firm’s insolvency risk is negative or positive.

For this reason, legal measures that consider only a debt’s face value, and ignore correlations, often produce results that are wholly unrelated to the actual opportunism hazard.

A failure to recognize the pivotal role of correlation in the economics of contingent debt is a major shortcoming of the Obama Administration’s proposed regulations for derivative contracts. Those proposals rely on standard measures for regulating fixed debt, such as higher capital and collateral requirements. If implemented, the proposals would raise costs for all derivative users, but would not block the speSHAREHOLDER OPPORTUNISM cific type of opportunism that creates the risk of another AIG, Fannie Mae, or Freddie Mac–style collapse in the future.

The correlation-seeking hazard also calls into question the administration’s philosophy on executive compensation. In the wake of the financial crisis, the Treasury Department has required senior managers at bailout recipients to take more of their pay in the form of company stock rather than cash. And the Federal Reserve has issued guidelines suggesting that it is considering similar executive pay rules for banks.

This emphasis on equity compensation implies that the administration is concerned primarily with conflicts of interest between managers and long-term shareholders. But at least at the biggest bailout recipients, the evidence suggests that the more serious problem was conflict between the interests of creditors on the one hand, and the interests of shareholders, as advanced by managers, on the other. And the administration’s pay approach, by further aligning manager and shareholder interests, only exacerbates this conflict.

These observations indicate that legal rules for contingent debt should be fundamentally rethought. For example, Congress should consider repealing special Bankruptcy Code exemptions that give derivative counterparties priority over other unsecured creditors. Those exemptions undermine the counterparties’ incentive to monitor in order to prevent forms of shareholder opportunism such as correlationseeking, even though the counterparties’ sophistication would make them better monitors than most other creditors. In addition, pay rules at systemically important firms should be set to protect creditors as well as shareholders. Finally, fraudulent transfer law should be reformed to permit courts to subordinate a contingent debt if a high correlation between the contingency risk and the debtor’s insolvency risk was apparent at the time of contracting. Such a rule would nullify the wealth transfer away from the debtor’s unsecured creditors, thereby reducing the incentive for shareholders to use such debts to expropriate wealth rather than create wealth.

This Article proceeds in three parts. Part I describes the economics of correlation-seeking. Part II shows how correlation-seeking explains risk-taking conduct at AIG, Fannie Mae, and Freddie Mac in the years leading up to the 2008 financial crisis. And Part III considers how lawmakers could redesign key legal doctrines to target the distinct opportunism hazard that contingent debt presents.


This Part analyzes the economics of contingent debt opportunism.

Section A explains why a positive correlation between the risk that a firm will fall insolvent and the risk that its contingent liabilities will be triggered enriches the firm’s shareholders at the expense of its unsecured creditors. Section B uses a simple numerical model to demonHARVARD LAW REVIEW [Vol. 123:1151 strate why lawmakers’ emphasis on fixed debt may be misplaced, and in particular why a contingent debt is a bigger opportunism hazard than a fixed debt of comparable size. Section C explains that correlation-seeking is especially pernicious because, unlike the forms of shareholder opportunism previously studied by scholars, it often reduces the level of risk borne by shareholders even as it increases shareholder returns. And section D explains why correlation-seeking generates various costs that destroy social wealth.

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