Do CDSs cause more bankruptcies?

April 20, 2009

Charles Davi has spent 1500 words replying in great detail to my blog entry about whether the CDS market has a deleterious effect on bankruptcy negotiations. He’s basically correct, as far as he goes, and indeed I did mix up an Event of Default with a Credit Event — my bad. But still I think he misses the bigger picture.

The problem, at heart, is this: debt negotiations are hard, arduous things. Nobody likes going through them — especially not big institutional bondholders, who can suddenly find themselves with 1% of their portfolio taking up 50% of their time. It’s something everybody wants to avoid if possible, especially since bondholders who engage in negotiations generally have to constrain themselves from trading in or out of the debt in question.

And so, at the margin, anything which makes it easier to ignore bond-restructuring negotiations is going to be jumped at by the creditors of any company. Given the choice between buying credit protection and entering into negotiations, most bondholders will happily buy the protection, even if it costs them a little bit more money.

I’m not for a minute positing the existence of protection buyers who actively seek to derail bond renegotiations so as to maximize the payout on their derivatives. Instead, I’m just saying that it becomes much harder for borrowers to renegotiate their bonds when the bondholders don’t particularly care what happens either way, because they’ve gone and bought themselves credit protection.

The problem with the originate-to-distribute model of mortgage lending was that the people who were meant to underwrite the loans couldn’t be bothered to, because they had no intention of holding on to them. Call it sheer laziness, if you like, if you don’t want to ascribe any malign intent, but the fact is that there’s an opportunity cost to getting dragged into long and boring procedures, and often a quick financial deal is much easier and cheaper than doing hundreds of hours of forensic and accounting homework.

I fear that the growth of the CDS market has made it altogether too easy for bond investors to simply rid themselves of troublesome considerations pertaining to companies in distress. Selling distressed bonds outright is extremely unpleasant; buying enough protection to limit your downside, by contrast, is simply prudent. Once you’ve done that, who can blame you for not getting bogged down in negotiations?

It’s far too early to say whether we’re going to see more bankruptcies as a result of this phenomenon, or even whether that’s necessarily a bad thing. But I do think it’s a legitimate concern.


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