Empty creditors and strong shareholders : the real effects of credit risk trading : fourth draft

Credit derivatives allow creditors to transfer debt cash flow rights to other market participants while retaining control rights. Theory predicts that this transfer can create empty creditors that do not fully internalize liquidation costs and liquidate borrowers excessively often. This empty creditor problem is concentrated in firms whose creditors would face powerful shareholders in distressed debt renegotiations. Consistent with this prediction, we show that (1) creditors buy more CDS protection when facing strong shareholders, and that (2) CDS trading reduces the distance-to-default, investment, and value of firms with powerful shareholders.