Credit Default Swaps and Control Rights

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 defaults 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.

Also published on the Atlantic Monthly’s Business Channel.

Originally published at Derivative Dribble and reproduced here with the author’s permission.

7 Responses to "Credit Default Swaps and Control Rights"

  1. Knute Rife   April 25, 2009 at 1:04 pm

    If the CDS market had adhered this closely to the insurance model, we would not be facing the problems with CDSes that we are. But while they were written like insurance policies, they were not marketed as such. They were marketed as securities, and so for many their value lay not in their coverage but in their transferability. Parties bought and issued CDSes with an eye primarily to selling them up and down stream, and they created an unwinding nightmare in the process. Because of the stigma CDSes now have, that behavior has been greatly curtailed, but there are still no regulations to keep it from happening. Until CDSes are forced to be treated as insurance, they are subject to being manipulated, including being used to stack the deck in a reorganization.

  2. Paul   May 1, 2009 at 9:17 am

    There is a flaw to this argument. Many “investors” who had a dim view of Chrysler bought protection with a view to profit on the widening of CDS spreads. As those spreads widened, and bond prices fell, they had every incentive to buy the bonds are distressed prices and either a) have a hedge against their position in CDS as a bail-out/non-default would cause bond prices to rise while CDS spreads would narrow or b) use the voting power of holding the bonds to force the company into bankruptcy so as to force payment on the CDS. It’s an option whose cost is only the downside of a bond already trading at distressed levels. And bonds never vanish, they usually have some residual recovery value making the trade extremely one-sided.Yes, this does not work after the company becomes distressed, but anyone watching the slow death march of the Auto companies could have put this trade on when it provided this almost free lunch. This “fat tail” of the return probability outcomes is the problem.

    • Paul   May 1, 2009 at 9:19 am

      And the “are” in the third sentence should have been “at” as in “At distressed prices”

    • Paul   May 1, 2009 at 9:25 am

      Oh. And I need to add: you cannot necessarily take profits on CDS contracts in the manner you suggest. OTC CDS have set maturities and while you can write a new contract (going the other way) to net out your position, only with agreement from your counter-party can you actually settle for cash. Sometimes you cannot simply write a new netting contract for the same reason you suggest: others might not be willing to take the other side of the trade.

  3. Anonymous   May 1, 2009 at 11:13 am

    I’m impressed. Finally we have figured out that CDS instruments are double swords, as Mr. Warren B. said vehicles of mass destruction. Why ?, because they can be used to insure a potential “play on a position”, hedge on the upside or downside, specially if the outcome either way can be controlled by the “position players”, those that purchased the CDS; it’s so much more fun when we get to see these wizards get away with the “play”.

  4. Guest   May 3, 2009 at 8:55 pm

    it is a sign of the times, when in the 21st century owners have found a way to profit from bankruptcy. (or fear of such). It would be interesting to see Adam Smiths view if he could of seen this, probably give up on economics, Hobbs would of included it is his theory, Marx would of been laughing, and Aristotle would have stricter guidelines on student entry into the Lucerne and Plato into his Academy and then question logic. ((o then p and r then s, then p or r equals p or s) o= owners, p= profits, r= owners control to bankruptcy, , s= bankruptcy) looks like Constructive Dilemma syllogism. thus win-win situation. wizards. a CD or CDS.The next phase is to see what becomes of this, as stated, companies are becoming smarter and footnoting this on contracts. I think the fed wont let this slip by, if there where calls for regulations this would be a place to begin. Its logical but not economical, cant have owners closing shop, layoffs would be enormous. No doubt insurance and protection is important, but that protection means less risk less risk means no rights to call. Nice trick to have both.What will these wizards think of next?

  5. Guest   May 3, 2009 at 9:06 pm

    where is were, second sentence, typing to fast