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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