Charles Davì

Credit Default Swaps and Control Rights

In Uncategorized on April 24, 2009 at 7:58 am

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.

  1. These may be naive questions, but here goes.

    Lets say a company (say GM) is in trouble. There are alot of CDS issues on these guys. Many of the issuers may have netted out, but some players really are long GM because they have issued (net) CDS on GM. It seems that these players might take an intrest in helping GM survive; but we haven’t seen that. Why not?

    Now lets suppose the CDS issuers have issued more net protection than there are bonds outstanding and the company does go bankrupt. Why would not the CDS issuers buy the bonds at any price up to par… this would limit their total exposure to be the amount of bonds outstanding. So far as I know, we haven’t seen that either. Again, why not? Is it just that the net value of CDS is always less than the value of bonds outstanding?

  2. […] The CDS restructuring-sabotage theory is seriously flawed (DD) […]

  3. […] The CDS restructuring-sabotage theory is seriously flawed (DD) […]

  4. […] The CDS restructuring-sabotage theory is seriously flawed (DD) […]

  5. […] 26, 2009 · No Comments Credit Default Swaps and Control Rights from Derivative Dribble by […]

  6. you are talking here about buying ‘protection’. the cds market is multiples the supposedly ‘protected’ bond market. for that reason, there is no insurable interest in most contracts, and therefore cds are not protection for bonds. you can find another confirmation: cds trade in much tighter correlation to equities than the bonds they supposedly ‘protect’. cds are pure and simple highly levered equity plays.

  7. Joe in Morontown,

    Your comment has nothing to do with the subject of the article. The only people with control rights in a restructuring ARE BONDHOLDERS. This article addresses the issue of bondholders who hedge their positions. So yes, the article is limited to those who buy protection on their bonds, because those are the only people that are of concern to the topic.

  8. Not everybody trades in CDO’s and toxic CDS’, on the opposite, I just came upon a website that states they have nothing to do with it: M Kapital Syndicate AG
    We all forgot that market is more about “real world trading”, not leverage on leverage LTCM style, but as it is hard to make money normal way, we founded abnormal environment that killed global economy and left many good bankers, brokers, traders unemployed as a result.
    ThumbsUp for the few, that do it old fashioned way.
    I think it’s worth a visit.

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