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June 01, 2006


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Are there really that many bankruptcies (more than in the past) with regard to which one can easily sell various claims? Or is it just a very few large entities? It would be hard to construct bankruptcy law around the minority of (even business) bankruptcies.

Presumably the reason a hedge fund might hold disparate claims in a single firm is that it knows more about the firm. We might even think that an investment in A's equity (long or short) increases the probability of an investment in various kinds of A's debt because of the superior information or insight about A. Each of these items or markets might be slightly mispriced. But if that is the best explanation for these investments (and that explains something very different from a simpler risk strategy) then we might have observed these sorts of investments a long time ago. In the pre-hedge fund world, it might have been that Corporation B held many kinds of claims with respect to Corporation B, in which case the bankruptcy point about a sophisticated investor would have been true.

Anup Malani

One way to view this, as you point out, is that ex post trading in claims caps collective action costs. Another way, however, is that perhaps bankruptcy law is not doing a good job (in these cases): bankrupcty process costs have risen to the point where participants have to take things into their own hands via ex post trading in claims. In order to determine which view is (more) correct, it would be helpful to have some info on whether costs of trading have fallen a lot and how much bankruptcy costs have grown. (It would be helpful to have a graph to illustrate; but you can see the picture.) Presumably participants are looking for the least cost method of resolving claims given limited liability. The interesting feature of this market is that, although bankruptcy and ex post trading compete, the uncertainty of bankruptcy outcomes will affect the prices that traders must pay with ex post trading (and perhaps the feasibility of ex post trades). So, in some sense, bankruptcy law has to both succeed and fail to facilitate ex post trading. Succeed by having clear enough rules to allow pricing of ex post trades. But fail in having process costs (e.g., delay) so high that ex post trading is preferred.


A couple of interesting comments. As to the frequency of cases in which there is an active market for claims, my sense is that relative to fifteen years ago, there are more cases where this happens (while they are still relatively few in absolute number, in economic effect they are large because they tend to be the cases with the largest amount of assets, and assets seems a better way to measure the effect of a bankruptcy system rather than number of cases) and that the markets are more active. It would, of course, be great to have hard data here.

As to Anup's point, I'm not sure that it captures the dynamic at work. Let's say that you sold wheat on credit to Interstate Bakeries. While bankruptcy cases today tend to move faster than in the past, there are still cases where the proceedings take some time (Interstate will hit the two-year mark in September). This is not necessarily a failure of the system. Some cases just need some time to sort out. Our wheat seller cares about liquidity, and really does not want to make any investment in figuring out what is going on in the case. His business model is selling wheat. It's not so much that the costs of bankruptcy have gone up; rather, it is that there is value that is created in two ways. First, by providing liquidity; second, by allowing some entities to gather sufficient claims so that they will make the effort to gather information and participate in the reorganization.

Hedge Fund Consultant - Richard Wilson

As to the first comment - I don't think there are many where you can sell various claims. Those are few and far between in my experience and discussions with young to mid-level professionals in the industry.

- R

Hedge Fund Blog

Do you have any easy to access white papers on this topic? I would like to write about this in my own hedge fund blog.

Thanks in advance.

- Richard

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