How the CDS market makes restructurings more difficult

By Felix Salmon
April 18, 2009

Commenter VM asks whether reduced incentives for bondholders to keep a company out of bankruptcy aren’t “a fairly horrible side effect” of the credit default swap market. Megan McArdle is thinking along similar lines, and her blog entry elicited a rather unconvincing response from Charles Davi.

To Charles’s point, no one is accusing cunning bondholders of finding “a serious loophole”, or “a nice way to make some fast cash”, or perpetrating a “restructuring-sabotage-strategy”. 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.

Let’s say that I buy $1 million of bonds. In order to protect my downside, I buy $600,000 of credit protection: if the issuer goes bust, I get $600,000, and a healthy 60% recovery value. I don’t want the issuer to go bust — I’d much rather the bonds continued to perform, and to be worth $1 million. But at least I can’t lose more than $400,000 in the event of default.

The issuer then gets into serious difficulties, and the bonds start trading at 25 cents on the dollar: my $1 million of bonds are now worth just $250,000 on the open market. The distressed issuer then seeks to avoid bankruptcy by entering into negotiations with its bondholders. “If we default and are forced into bankruptcy,” they say, “then bondholders will end up collecting no more than 20 cents on the dollar in a liquidation. But if you agree to a restructuring which keeps us out of the bankrupcy court, we can get you a good 45 cents on the dollar in value.”

Normally, bondholders would be well disposed to such an offer. But in this case, I might think twice. If the restructuring doesn’t count as an event of default for the purposes of the CDS contract, then I might end up with just 45 cents on the dollar — $450,000 — if I agree to the company’s plan. If I just let it go bust, on the other hand, I get $600,000.* And so I have an incentive to opt for the more economically-destructive option.

Now there’s one big problem with this story: any 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.

But the fact is that whenever bondholders have bought credit protection, someone else — the protection seller — is in the position of caring deeply whether or not a restructuring goes through. But at the same time, that person can only cheer from the sidelines, and has no actual role in the bondholder negotiations, since they’re not a bondholder. Meanwhile, the bondholder doesn’t care nearly as much about the outcome of the negotiations as the issuer would like, since a lot of his exposure is hedged either way.

All of which leads Megan to propose that “swap contracts should allow the issuers to get involved in these negotiations, the way insurance companies sit at the table during lawsuits”. This is a bad idea, since there’s no limit to the amount of credit protection which can be written on any given issuer. A company thinks its dealing with a known quantity of bondholders, and then suddenly sits down at the restructuring-negotiation table to find ten times as many protection sellers? No one wants that.

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.

The real solution here is to minimize the economic costs of bankruptcy. If the outcome of bankruptcy proceedings is that creditors end up with just as much value as they would have gotten from a restructuring, then there’s really no problem either way. When it’s done well, bankruptcy is little more than a change of ownership: shareholders get wiped out or diluted, and the old creditors become the new owners. The company itself doesn’t need to change much at all.

But there are certainly times when a constructive bond restructuring is going to create much more value than a drawn-out bankruptcy proceeding. And the existence of the CDS market does make such restructurings more difficult — just as the fact that mortgages have been sliced and securitized makes mortgage modifications more difficult.

Restructuring bonds outside bankruptcy is never easy — and that in fact is one reason why the bond market is normally so healthy: both issuers and investors know that companies can’t easily go back on their promise to pay what they owe. That helps to bring down the cost of funding for all companies in the bond market. But in times like these, when restructurings sadly become necessary on a large scale, having a lot of bonded debt is a problem. And when that bonded debt has been hedged in the CDS market, the problem becomes bigger still.

*Update: Hemant, in the comments, points out that I actually get $700,000, not $600,000: I get $600,000 from the hedged portion, and also another $100,000 (25% of $400,000) from the unhedged portion.


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Not sure if this is right, though doesnt change the argument ; “if I agree to the company’s plan. If I just let it go bust, on the other hand, I get $600,000.”
If I let it go bust, I will get 25 cents on 1 mio notional from the company (250K) + 75 cents on 600K notional from CDS seller (450K), for a total of 700K.

Posted by Hemant | Report as abusive

“The whole point of issuing bonds is that they’re tradable, fungible, and anonymously held.”

There is no anonymity in bond holdings. Anonymous bonds are called bearer bonds (as in pay to the bearer). From a combination of legal rules, there haven’t been barer bonds issued in over 20 years. Most securities these days are registered in some form or another (often to the broker), my understanding is that’s how they send you the coupon or dividend.

I wrote that no bearer bonds had been issued in 20 years. I guess I don’t really know that, there may be a few that slip through the current legal net. But if they are still around they are a small part of the market. Most bonds are not anonymous.

Let me try and understand this: I own a bond of a particular company that I bought expecting to be paid a certain amount. To protect my investment, I accept the extra investment of insurance on that bond. I thereby lessen my risk, and increase my expenses. Another bond buyer doesn’t buy insurance and has more risk. What on earth is wrong with that? It makes perfect sense to me.

So, the company is trying to restructure outside of bankruptcy. Let’s leave the type and point of bankruptcy out of it in this case. I can either accept a deal from the company or hold out for bankruptcy, depending upon what is better for me. Isn’t that our system?

The company can induce me to accept their restructuring plan by convincing me that they have a plan that will pay off for me in the long run, etc. If they don’t have one, I shouldn’t have to accept their plan.

As near as I can tell, we’re trying to create a system where my taking less risk is to be penalized because it might not fit some other person’s view of whether or not a particular company is worth trying to save. Weird. Another day, another weird and paradoxical proposal. I surely must be misunderstanding this argument. I must be very tired. I apologize.

Ideally, bankruptcy rules would be such that there would never be a reason to restructure outside of bankruptcy; bankruptcy exists for the purpose of restructuring. How close we can come to an ideal system is an open question. We could certainly come closer.

This is reminiscent, though, of a situation a couple years back where a hedge fund holding a bunch of debt bought a bunch of the company’s stock while selling it all forward so that they could vote the shares in favor of an issue that benefited bondholders. In principle you could argue that it’s the responsibility of the buyer of the forward to monitor and/or charge for this, and in practice if this were quite common, I imagine its possibility would get priced into the forwards and/or some steps would be taken to ameliorate it. CDS sellers might be expected to tend toward the same behavior. How long that would take in practice, how far it would go, and what collateral damage it would do to the markets of the derivatives and the underlying cash securities are probably harder to guess and unlikely to exactly line up with market efficiency.

It is my humble opinion that capitalistic systems only work when the owner bears the direct risk of his/her investments. This provides a powerful incentive to invest wisely, and hence allocate capital to productive uses. It also provides a powerful incentive for the owner to be actively involved, demanding that management make the occassional tough choices necessary to keep the business sound.

Bonds that are insured create direct owners that do not bear appropriate risk of loss. Index mutual funds create direct owners (the management company) that do not bear the risk of loss. Throughout our entire financial system, we have found cleaver ways to divert risk from the direct owner in the name of ‘risk management’.

Show me a capitalistic system in which the direct owners do not bear the risk of loss, and I will show you a capitalistic system that cannot properly allocate capital, and is destined to failure.

Posted by Tom Cole | Report as abusive

If you believed that the out of court restructuring would happen and would increase the price of the bonds you would close out the CDS. That way, you make money on the CDS and on the bonds that you originally bought. This happens a lot with put options on equities. You buy the put as protection against a position you have on and when you think that the bottom is in you sell the put.

Posted by Aiden | Report as abusive

I think both you and Hemant have the math slightly off in your example.

You bought $600,000 in CDS protection, which you get in the event of a default. Also, you hold a $1 million bond, and you “will end up collecting no more than 20 cents on the dollar in a liquidation.” So you’ll get an additional up to $200,000 on the bond. That puts you at between $600,000 and $800,000, so I guess we’re all right?

There’s no “$400,000 unhedged portion” of the bond; the CDS contract is orthogonal to the bond itself

Posted by Jacob | Report as abusive

Restructuring is a credit event (not an event of default, but something that triggers the CDS) in all standardised corporate CDS: “Restructuring covers events as a result of which the terms, as agreed by the reference entity or governmental authority and the holders of the relevant obligation, governing the relevant obligation have become less favourable to the holders that they would otherwise have been. These events include a reduction in the principal amount or interest payable under the obligation, a postponement of payment, a change in ranking in priority of payment or any other composition of payment. A default threshold amount can be specified.”

Posted by Ginger Yellow | Report as abusive

Ginger, so how are equity for debt swaps handled by a CDS? If I insure bonds to $10 and a restructuring happens that changes their value to $2 and a bunch of equity do I get paid the $8 difference irrespective of the theoretical value of my equity? Or is the equity valued at some level?

Posted by crack | Report as abusive