CDS defenders protest too much

December 21, 2009

NeilUnmack2.jpgBy Richard Beales and Neil Unmack

Critics of credit default swaps (CDS) like the “empty creditor” hypothesis.

The theory is that buyers of credit insurance can profit by allowing — or even encouraging — companies to file for bankruptcy. It’s used as an argument for banning or severely restricting the $31 trillion CDS market. In reality, the empty creditor hypothesis is probably half full.

CDS instruments allow traders to insure themselves against a company’s default. Empty creditors are investors who have hedged with CDS and who stand to benefit if companies go bust, because the CDS would make them whole on the value of their debt.

The International Swaps and Derivatives Association (ISDA) set out to rubbish the hypothesis in a research paper published on Dec. 17. ISDA is right to debunk one element of the theory — the notion that CDS traders can make quick profits from a company’s final spiral into bankruptcy.

The big flaw in this idea is that buying bankruptcy protection in CDS markets gets very expensive as companies near failure. At the end of 2008, the cost of insuring against default on $10 million of General Motors bonds in the CDS market was $8 million — payable up-front — plus $500,000 a year for up to five years. That was almost six months before GM finally filed for bankruptcy on June 1.

Upon bankruptcy, CDS buyers receive the insured amount less the recovery rate on the bonds. In GM’s case, the recovery rate was set by auction at 12.5 cents on the dollar. That means someone who bought CDS half a year before the company filed would scarcely have broken even.

In the immediate run-up to GM’s bankruptcy the trade would have been loss-making. Fingering CDS traders for companies’ short-term problems or final death throes is much like blaming short-sellers of stock. Both are almost invariably the messengers, not the message.

But ISDA is mistaken in trying to knock down a central thrust of the empty creditor hypothesis. This argues that investors owning a company’s debt as well as the related CDS can prevent or distort a restructuring outside bankruptcy if the company gets into trouble. After all, blocking alternatives so that a firm eventually has to file for bankruptcy would trigger a fat payout on the swaps.

As far as ISDA is concerned, there is no evidence that the ratio of bankruptcies to out-of-court restructurings has picked up since the credit derivatives market boomed. Still, the fear is that this dynamic could force companies into an otherwise avoidable collapse — or at least interfere with a restructuring. It’s fodder for those who want to ban CDS, or at least want creditors who hedge with CDS contracts to have restricted voting rights.

And despite ISDA’s conclusion, credit derivatives clearly do in practice sometimes gum things up when companies are trying to negotiate out-of-court restructurings. Some of these debt rejigs, as well as outright bankruptcies, can trigger payouts on CDS contracts.

Whether that happens can depend on the terms of the restructuring, an interaction that has caused uncertainties in several recent cases, including a debt exchange carried out by Mexican cement giant Cemex. Wind Hellas, the Greek telecoms company which recently entered a pre-packaged administration, said attempts to restructure its debt would have been complicated by the presence of CDS holders.

Companies need to bear this issue in mind when they draft credit agreements. But instead of playing down the issue, ISDA could help too. The industry group has already missed a trick or two in the face of widespread criticism of derivatives trading practices that go well beyond CDS instruments. Rather than trying to defend everything about the industry, it should emphasize the useful features of derivatives markets while recognizing, and trying to address, their flaws.

This means making a concerted effort to find better ways to manage the difficulties posed by CDS-owning creditors in restructurings. The extreme solution — draconian curbs on the voting rights of hedged investors — would not be workable. But a good first step could be full disclosure of which creditors are hedged with CDS before restructuring discussions begin.

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