Credit Default Swaps and Control Rights, Redux

Also published on the Atlantic Monthly’s Business Channel.

Felix Salmon and I are usually on the same side of the jury box when it comes to the trial of credit default swaps. However, it appears we have reached an impasse concerning creditor control rights in the context of restructurings and bankruptcies. While that sounds like an awfully narrow issue to quibble about, the policy implications of this seemingly obscure issue are far reaching and call into question both the orderly functioning of the debt markets and the soundness of the current bankruptcy regime.

Let’s begin by outlining the issue at hand. In my previous article, I wrote:

Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC’s bankruptcy. The problem seems obvious: B either doesn’t care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.

In fairness to Felix, here’s his added qualification of the issue from his response to my article:

The problem is a bit more subtle than that, and is simply that bondholders who have bought CDS protection have much less incentive to participate in restructuring negotiations.

The key to understanding why we shouldn’t expect this change in incentives to lead to any material change in the restructuring process is rooted in the distinction between incentive to act and power to act. Clearly, anyone who expects to profit more from option A than B will choose A given the chance. And so, a bondholder who expects to receive a larger payout from CDS than from a restructuring will choose the CDS payout given the chance. But does that bondholder have any power to bring this result about? As a general matter, probably not.

One Is the Loneliest Number

Restructurings generally take place across the entire capital structure of firm. A firm could have multiple issuances of bonds, loans, and may even have other hybrid debt-equity financing. Each class of creditors has holders with certain control rights. While this complicates the restructuring efforts for the firm, since the firm will have to coordinate with various classes of creditors which may have competing incentives, it also mitigates the influence that any individual creditor/creditor-class can exert on the restructuring process. In addition, it usually means that the firm will require different thresholds of creditor approval from each class. For example, ABC concludes for a given restructuring plan that it needs the approval of 75% of class A holders, 60% of class B holders, etc. The actual threshold will be determined in large part by two main drivers: (i) the agreements that determine the rights of each creditor class (ii) and the number of on-board creditors needed to make the deal economically feasible.

So, even acknowledging the clear incentive on the part of those who stand to gain more from a bankruptcy than a restructuring, their impact on the success of the restructuring will be determined by their ability to affect the firm’s ability to achieve the required thresholds. Thus, their impact will be determined by their ownership stake in the debt. And so, in order for Felix’s argument to be taken as a serious point of concern, we must posit the existence of a class of hedged creditors who stand to gain more in bankruptcy than restructuring that is so large and well coordinated that it is able to obstruct the restructuring efforts of the firm and those creditors that stand to gain more from restructuring than bankruptcy. While not impossible in a nominal sense, this strikes me as a rather fortuitous state of affairs.

Bankruptcy Is Not A Sure Bet

In analyzing the incentives of the participants, Felix assumes that bankruptcy is certain in the case that a restructuring fails. This is not necessarily the case. He wrote:

I might end up with just 45 cents on the dollar — $450,000 — if I agree to the company’s [restructuring] plan. If I just let it go bust, on the other hand, I get $600,000 [from CDS]. And so I have an incentive to opt for the more economically-destructive option.

Every filing for involuntary bankruptcy is reviewed by a judge and can be contested by the debtor. And CDS don’t payout until judgment is entered against the debtor. That means payout under a CDS as it relates to bankruptcy is an uncertain event. That means that your expected payout should be discounted by the probability that the event will occur. So in the example above, the expected payout should be some fraction of $600,000, which could easily bring it below the $450,000 indifference point.  What’s worse, that probability might be impossible to calculate for your average bondholder, which holds its bonds passively and is not likely to have access to up to the minute progress reports on the firm’s financial condition or the restructuring process.

Review by a judge also means that only meritorious claims for bankruptcy will survive. And so, again, we run into the distinction between the incentive to act and the power to act. That is, whether or not someone would like a firm to go into bankruptcy, its ability to cause that to occur is restricted to only those circumstances where it would have been permissible anyway.

Covenant Thy Lender

In the previous article, I suggested that if companies were truly concerned about their creditors stocking up on CDS and fouling up restructurings, they could require the bondholders to promise to not hedge beyond a certain threshold. Felix responded with the following:

And Charles Davi’s idea that companies could somehow constrain their creditors from buying credit protection is even sillier — and probably illegal. The whole point of issuing bonds is that they’re tradable, fungible, and anonymously held. You can’t covenant up bondholders in the same way you can with bank lenders.

First, loans are covenant-heavy for the borrower, not the lender. That’s why companies like issuing bonds in the capital markets, as opposed to taking on loans. Second, without commenting directly on the legality of the scheme (though I’ll note that Felix cites no authority for his claim), it is common place in the MBS market for large, wrapped deals to condition voting rights on bona fide economic exposure. In a wrapped deal, there’s an insurer that guarantees payment on the bonds. If the bonds don’t pay, the insurer does. In these types of deals, the insurer controls all of the bondholders’ voting rights, unless the insurer defaults or goes belly up. So, what bondholders have in these deals are bonds whose voting rights are contingent upon their exposure to risk.

If CDS were truly a problem in the context of restructuring, I would expect companies to issue bonds with voting rights contingent upon maintaining bona fide economic exposure, in a manner analogous to what is done in the MBS market. That said, I wouldn’t expect them to be very popular with bondholders.

Note that this voting restriction would not affect tradability or fungibility at all. The bonds would still be identical and therefore completely fungible.

The “Restructuring” Credit Event

Finally, Felix misstates the requirements for recovering under a restructuring. He wrote:

[A]ny restructuring as drastic as the one I described would count as an event of default — so owners of credit protection would get paid out either way.

That is simply incorrect. First, an “Event of Default” is distinct from a “Credit Event.” A Credit Event is caused by the issuer referenced in the CDS. An Event of Default is caused by one of the two parties to the CDS. The former triggers a payout under the CDS. The latter triggers a payout for damages, in essence for breach of contract. For example, if X and Y enter into a CDS naming ABC Co. as the reference entity, any failure by ABC to make a payment on its bonds would be a “Credit Event” and would trigger a payout, let’s say from X to Y. Any failure by X or Y to make a payment required under their CDS would be an “Event of Default.” The two concepts are completely distinct.

More importantly, Felix misstates the circumstances under which payout occurs. At the outset of a CDS trade, the parties will agree which Credit Events will cause a payout. And indeed, Restructuring is one type of Credit Event. However, only those parties who specifically elect Restructuring as a Credit Event will be entitled to payout upon the occurrence of a restructuring. As such, his analysis of the incentives of participants, which assumes that all trades include Restructuring as a Credit Event, is flawed.

Most importantly, if someone is using CDS to truly hedge against credit risk, they will elect to have Restructuring as a Credit Event. Assuming that this is the case, Felix’s entire argument is out the window, since in that case, the hedged creditor is either indifferent towards or, in the case he’s over-hedged, has an incentive to see the Restructuring succeed.

Credit Default Swaps and Control Rights

Also published on the Atlantic Monthly’s Business Channel.

Megan McArdle asks, “Do We Hate Credit Default Swaps for The Wrong Reasons?” As Megan notes, blaming credit default swaps for all kinds of things is quite fashionable these days, since simply uttering the term makes commentators feel sophisticated. While this is itself a topic worthy of discussion, the more interesting point in Megan’s article concerns how credit default swaps affect the incentives of bondholders in the context of restructurings.

The basic argument is as follows: Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC’s bankruptcy. The problem seems obvious: B either doesn’t care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.

At first blush, this looks like a serious loophole and a nice way to make some fast cash. Sadly, there are several reasons why this is not the case. The key factor to understanding why we shouldn’t expect this to be a major problem is to appreciate that there is no CDS vending machine. You cannot go to the market and demand credit protection on all of your bonds at your whim. You have to find someone willing to take the exact opposite position that you are taking. That is, if you bet heads they bet tails, by definition. As a result, if everyone knows the next toss is coming up heads, you probably won’t find someone to take the opposite side of that bet.

As discussed above, when you buy protection, you (the protection buyer) buy it from someone else (the protection seller) who will end up paying out if a bankruptcy does indeed occur. These protection sellers are very interested in making money, and so, as the probability of default increases, the price of protection or “spread” widens, making it more expensive to purchase protection. So, as firms get closer to a restructuring or bankruptcy, the cost of buying CDS protection on soon-to-be-junk bonds skyrockets. And not only does the cost of protection go up, liquidity, or your ability to enter into CDS trades, on distressed entities dries up. There’s a fine reason for this too. As the probability of default edges closer to certainty, fewer people are willing to take the other side of the trade. They’re just as convinced as you are that ABC will fail, and they’ll tell you to go sell your bridge to someone else.

This means that in order to take advantage of the restructuring-sabotage-strategy, you have to either (i) guess which companies are doomed for failure well in advance of any real trouble; or (ii) wait for trouble and then lay out a ton of cash and find someone stupid enough to take the obviously wrong side of a bet with you. Neither scenario seems likely to occur often, since (i) requires some fairly remarkable foresight and (ii) requires remarkably stupid counterparties. Moreover, in the case of (i), if you’re truly convinced that ABC is headed for restructuring or bankruptcy, you can buy protection with “Restructuring” as a credit event, which means that if ABC does restructure, you’ll get paid. So, in that case, you don’t have to sabotage anything. You can just sit back and wait for an ABC restructuring or ABC bankruptcy, since you’ll get paid in either case.

Moreover, rather than waste all that time and effort trying to sabotage a restructuring, you can cash in before a bankruptcy ever occurs. As the spread widens beyond the point at which you bought in, your end of the trade is “in the money,” and so it already has intrinsic value that you can realize in a variety of ways. For example, assume that when you bought protection on ABC, the spread was 150 bps. When rumors abound that ABC is entering talks with its bondholders, you can be sure that the spread will be well above 150 bps. Let’s say that the spread widened to 1000 bps. As a protection buyer, your side of the trade has economic value that you can realize by entering into another trade in which you sell protection to someone else. (The CDS market has recently begun changing the way CDS spreads are paid, but we’ll assume we’re operating under the old system where the protection buyer pays the spread in quarterly installments). That is, you sell protection at 1000 bps, pay for protection at 150 bps, and keep the remaining 850 bps for yourself. Sure, you could go for the gold and sabotage a restructuring, but that’s a lot more involved than simply entering into an offsetting trade and pocketing the juice.

In addition to the market based reasons above, there are corporate governance reasons why we shouldn’t coddle these kinds of claims. When a company issues bonds, it includes terms that it and its bondholders must live up to. That is, each bondholder could be asked to swear on a stack of bibles that, “I will not go out and buy CDS protection to the hilt and ruin you.” If a company were truly concerned about the risk of restructuring-sabotage, it would include such terms.

The Regulatory Pendulum And Electoral Guillatine

Also published on the Atlantic Monthly’s Business Channel.

The conventional wisdom is that market regulation goes through booms and busts as the public oscillates through its love-hate relationship with the capitalist ethos. When all is well, high-earning executives are the embodiment of capitalism’s well-oiled wealth distribution machine at work. When all is not well, they are the embodiment of the structural deficiencies inherent in a capitalist society that favor those on top. Moving in sympathy with public sentiment, the regulatory pendulum swings from what some consider under-regulation to what others consider over-regulation, blowing past the inevitable resting point, and pausing only at the extremes.

This phenomenon has a simple, albeit unscientific explanation that would surely disappoint Galileo. During booms, deregulation is less contentious since the public is punch-drunk on the boons of capitalism’s bounty. And so, during booms, politicians can garner campaign funding from and scratch backs with those that have an interest in deregulation, all without taking much of a public flogging. During busts, regulation is politically advantageous since the public will be eager to blame someone for the economic malaise. Those who benefited the most during the preceding boom make easy targets, and so politicians can earn points with the electorate by appearing outraged at the conduct of under-regulated, overpaid executives. My sources tell me that this is to go on, back and forth, in perpetuity, leaving reason and prudence by the wayside.

Getting What You Want

Some might say that this process is inefficient, since the market swings back and forth from poindexter to cowboy, missing opportunities in the former case and betting the farm in the latter. I agree. However, there’s also an argument to be made that this behavior pattern is preference maximizing, at least at the time it occurs. Simply put, during booms, the public is wide-eyed and wants to believe that one day they too will have a CEO haircut and a Learjet. During these times, the public wants to see business at work, unfettered by those pansy leftists who just want to choke the life out of the American Dream. During busts, people are frightened, crave security, stability, and most importantly, someone to blame. The public will quickly abandon its love of well-oiled hairdos and private jets, and demand an accounting for the harm that’s been done. In each case, our elected representatives give us want we want at the time, and so we are satisfied at each juncture. If we add in the assumption that people make decisions based on short-term expectations (some modified version of a preference for present consumption), we have a reasonable theory as to why the phenomenon persists.

Given the opportunity to choose a different overall strategy from a neutral perspective,  something akin to Rawls’ “viel of ignorance,” we would, hopefully, chose a regulatory structure that maximizes our preferences over the long run. But assuming that human decision making is dominated by short term expectations, we will continue to prefer extremes and our representatives will continue to take extreme actions.

And so goes the hapless and headless story of the free world.