Why Ignoring Correlations Will Lead To Another Financial Fiasco
Is correlation seeking a new bias?
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 purchases can 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.