Do CDSs cause more bankruptcies?

By Felix Salmon
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.

10 comments

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Felix, if I didn’t know better, I would say it sounds like you are finding less and less justifications for CDSs every day…

Posted by KenG | Report as abusive

A long time ago, about last September, when Lehman went bankrupt, I remember the words “hoisted”, “petard”, and “bankruptcy”, being used together quite a bit. The idea, as I remember it, was that bankruptcy had gotten way too hard, and bankruptcy should be made easier.

Whoa Nellie! Not so fast. Now we want bankruptcy to be harder. About the only thing that the two views have in common is a distaste for creditors, meaning people who lend companies money and have the audacity to want to get paid back and make money.

Talk about shooting yourself in the foot with a bazooka. How does it help us to market the buying of bonds as a flight to a haircut? Perhaps we should make the lending of money to companies more like charitable donations.

I favor a tax cut for investment. One way to do this is to get investors to want to buy corporate bonds. Mandating risk is not a good way to do that.I am seriously perplexed by these proposals.

Either people will stop buying bonds or they’ll demand much higher interest for their investment, meaning lower profits and wages.

What am I missing?

Salmon: “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.”

Good point, but the fact remains that the CDS is a debt instrument anyway and when it comes to insolvency it weighs just as heavily in the issuing company’s accounting. It’s like having a risk covering band-aid that covers the sore but doesn’t heal it.

OK, you call it laziness and I’ll call it professional negligence but the entire process of securitization is being shown for what it boils down to — nobody wanted to take the risk for what was awful an credit lending mechanism without any sense of creditworthiness verification to establish debt riskiness.

The people responsible for this negligence were daft. And, obviously, too-big-to-fail. So we the taxpayer are now expected to poney-up their salvation?

Phooey, I say. Many Americans would be sooooo happy to see some perp-walks of the idiots who conceived this negligently bad process of Risk Management. They are or were in the regulatory system somewhere.

Justice done to them would be a salutary lesson for the future, of which our country seems to need more and more.

Posted by Lafayette | Report as abusive

CDS’ were like the rating agencies- another excuse for investors to not have to do due diligence before investing. there was plenty of laziness to go around. What was overlooked was the fact that you were just swapping your default risk from one party (the debt issuer) to antoher party (the CDS counterparty). However, if the CDS counterparty was large enough (i.e. AIG) your counterparty was really Uncle Sam.

That which is complicated can be confusing. That which is confusing, at times, can be clever deception. Transparency is good. Simplicity is better. Then the opportunity for deception is limited. Mortgage backed securities, hedge funds and CDSs exist because our government repealed regulations over the financial industry that were put into law in response to the Great Depression.

“Those who fail to learn the mistakes of the past are doomed to repeat them”, Victor Hugo.

Posted by Anubis | Report as abusive

If a CDS writer takes physical delivery of the bond in a credit event, can they then get a seat at the negotiating table? This would seem to give another benefit of CDS – a firm could specialize in writing protection and negotiation with creditors, maximizing value in credit events, similar to how auto insurers are better litigators if an auto accident is disputed.

If CDS writers don’t have the right to sit at the negotiating table after taking delivery, perhaps it would be better to reform bankruptcy code to give them that right rather than get rid of or try to minimize credit default swaps?

Posted by Jose | Report as abusive

My experience tends to agree with yours, with some caveats. First, having CDS changes the dynamics of the all-important creditors committee, from its inception and composition to how it votes. We’ve always had creditors with different incentives – such as suppliers generally want restructuring and continuance while financial creditors may want liquidation and payoff. Negotiation occurs not only between the debtor and creditors but among creditors, which is where the real deals are made. That’s important to remember and CDS shift the balance.

Second, another dynamic is that when a bondholder is protected that costs leverage because it’s recognized by the judge – who has tremendous power.

Third, the problem is that we’ve effectively altered these processes ad hoc. I don’t see them as a problem per se because they’re really only versions of what has always existed.

Fourth, one can argue that protection should be mandatory. This would change the bankruptcy dynamic again, because then the focus would tend to be not on financial creditors but on physical creditors who have a real stake in the actual business.

Posted by jonathan | Report as abusive

The HBS thesis for 2010 will be the CDS effect on GM bondholder negotiations. Theories here will be slightly more difficult to prove because the bondholders/CDS holders have the luxury of placing blame on the UAW for any failed negotiations rather than admitting that they might be getting a better payout in bankruptcy because of their hedges. And how beautifully the UAW are falling into the pawn role in this chess game!

The GM idea is good fodder for the bankruptcy case, now, here’s fuel for the opposite side of the spectrum. Pundits have failed to realize yet that FASB 157e has given CDS WRITERS the benefit. Despite whether investors will believe the level 3 marks proffered by banks, the whole essence of FASB 157e has made for less of a probability of default or credit event occuring. Because, for example, Citigroup can prolong the suspension of disbelief in a rubber stamped way, it’s no longer a higher certainty that the bank will implode. CDS writers should be lessed stressed by this, and hopefully, exerting decreased pressure on banks in a hedging sort of way.

Posted by Carpe | Report as abusive

Annubis: “Those who fail to learn the mistakes of the past are doomed to repeat them”, Victor Hugo.

Good notion, wrong author – who is George Santayana.

Posted by Lafayette | Report as abusive