US Government Debt Different - Finance Department - University of ...

Richard SquireCDS on USA and Correlation-Seeking83There is a type of investment strategy that, counter-intuitively, couldmake firms whose insolvency risk is highly correlated with that of theUS Treasury more likely to sell CDS on USA. This strategy, whichelsewhere I have termed “correlation-seeking,” 37 is a form of debtoropportunism in which a firm’s managers use contingent liabilities—such as those created by CDS—to transfer value from the firm’sunsecured creditors to its shareholders. 38 Correlation-seeking in themarket for CDS on USA could cause the contracts to be underpricedand the liability risk to be over-concentrated. To date, there is nodirect evidence that correlation-seeking is occurring in this market.But the likelihood that the solvency of many large financial institutionsis tied to that of the US Treasury suggests that correlationseekingis nonetheless a hazard, and that regulators should monitorfor signs of its emergence.In general terms, correlation-seeking occurs when a firm sells contingentclaims against itself whose risk of being triggered is stronglycorrelated with the firm’s insolvency risk. The fees collected from thesales enrich the firm’s shareholders as long as the firm remains solvent.And if conditions arise that cause the contingent liabilities tobe triggered, the high likelihood that the firm will then be insolventmeans that the liabilities will probably be borne not by the shareholders,but rather by the firm’s general creditors, whose recoveriesin the insolvency proceeding will thereby be diluted. To be sure, thefees collected from the sales may be part of the firm’s estate and hencemay augment creditor recoveries. But it can be shown as a matterof simple arithmetic that the fees will be inadequate to offset theexpected dilutive impact on unsecured creditors as long as the firm’sinsolvency risk and the contingency risk are positively correlated. 39In this way, the sales of the contingent claims transfer expected valuefrom the firm’s general creditors to its shareholders. Unsecured credi-37 Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv. L.Rev. 1151 (2010).38 A simple and prevalent example of correlation-seeking occurs when a parentcorporation issues a guarantee on the debt of a subsidiary whose equity is among theparent’s primary assets. See Richard Squire, Strategic Liability in the Corporate Group,78 U. Chi. L. Rev. 605 (2011).39 See Squire, note 37 above, at 1159.