Why Credit Default Swaps Encourage Bankruptcy

From Salon

Here's how it works: A lender buys the bonds of a company -- let's say General Growth, the huge mall operator that declared bankruptcy this week. But then, hoping to hedge against the risk that General Growth might default on its bond obligations, the lender purchases a credit default swap protecting against that event from another party, in effect buying insurance against the chance that those bonds will go bust.

But the kicker is that owning a credit default swap on General Growth bonds turns out to make the lender less willing to cut a deal that would allow General Growth to avoid bankruptcy, because the lender can get paid in full in the event of that bankruptcy by collecting on the insurance policy. So it's better for the lender to force the company to its knees rather than come to a less disastrous arrangement.

"We have seen CDS becoming a significant factor" when negotiations on out-of-court restructurings fail, said Alan Kornberg, the partner in charge of the bankruptcy practice at Paul, Weiss, Rifkind, Wharton & Rice, speaking generally. "We used to talk about the practice theoretically but now we see cases where it is hard to get lenders to agree to tender or to compromise and then you find out that these holdouts had significant CDS protection."

Comments

[psychodave]

Perversely, this may lead to a more efficient allocation of capital. In this case, away from over-leveraged investments in commercial real estate, for which the supply is already quite ample.

However, I assert that the more important policy issue is that the bondholder enjoys this position of strength in the negotiations solely because the U.S. taxpayer will step in to "pay in full" should the original CDS seller not be able to fulfill their obligation.

I don't have a dog in this either way.

What distresses me is that the hard physical policy of government intervention to give the bondholders this new advantage is never made explicit, by either administration. Quite the contrary, it is spun as a rescue of the financial system and the advantage given the bondholders will be spun as an unforeseen consequence.

[Steve Ross]

I can see the logic here but, wouldn't it then make sence for a company trying to avoid bankruptcy to negotiate instead with the company that holds the cds on their debt?

[greg]

Steve, you're question actually demonstrates exactly why this is a perverse problem. The CDS writers have no rights to prevent bankruptcy. Only debt holders can change the terms on the debt. So the people with the actual risk are not the ones with the right to renegotiate.

[psychodave]

Excellent points.

My only contribution would be to point out that CDS writers are of such little substance that they do not even have the capital to prevent a bankruptcy. I.e., they have no right, and no capacity, to prevent bankruptcy.

If I understand things correctly, CDS writers need a government bailout just to pay employee bonuses.

With such inadequacy, I find it strange our financial regulators allow a CDS to be treated as Tier 1 capital.

[John Beck]

Credit default ratios have been increased according to the financial portfolio of banks with respect to past history.