CDS and valuing control rights

By Felix Salmon
April 22, 2009

Craig Pirrong weighs in with a very long post on the question of whether credit default swaps make bankruptcies tougher. He has a perfectly good way of looking at the problem, but comes to the wrong conclusion, I think because he has a very skewed idea of the costs and benefits involved in the transactions:

A completely hedged debtholder (i.e., a party that has purchased protection in an amount equal to his holdings) would appear to have no incentive to behave constructively during the reorganization. But this means that a potential source of value—the control and legal rights attached to the ownership of the debt security—is not being maximized. There is therefore a set of mutually beneficial transactions that would leave the insured debtholder no worse off than if he acts in the passive manner that the critics of CDS hedgers suggest, but would result in the efficient exercise of the control and legal rights. Specifically, another party could purchase the debt from the insured current holder at a price that is satisfactory to the latter, but which allows the purchaser to capture some of value associated with the control rights. That is, there is a set of transactions that would allow the hedged debtholder to capture some of the benefits of the control rights.

The problem with this way of looking at things is that it essentially ignores the whole reason why the bondholder hedged with CDS rather than simply selling his bonds in the first place. Pirrong claims to be conducting what he calls a Coasian analysis, but he never attempts to explain, in terms of that analysis, how we got to the state of affairs which allowed this problem to crop up.

There’s a big reason why the CDS market exploded as it did: especially when it comes to small and/or distressed credits, it’s vastly more liquid than the cash-bond market. And it’s worth noting that Pirrong’s proposed solutions generally involve trading the cash bonds rather than credit derivatives.

Note that Pirrong is perfectly happy, in his ivory-tower way, to posit trades which capture what he calls the “value associated with the control rights” of a cash bond. But very few people trade in such value: basically, it’s the province of a small number of distressed-debt funds who like to buy debt cheap and then wade into invariably-arduous litigation. Those funds tend to have extremely high target IRRs, which makes Coasian arbitrage of the sort outlined by Pirrong very difficult.

Writes Pirrong:

The anti-CDS argument holds only if transactions costs materially impede the consummation of value enhancing bargains, but those advancing this argument undertake no analysis of transactions costs.

The first bit is right, but the second bit is wrong: I concluded my first blog entry on the subject by saying that the answer to the problem was to “minimize the economic costs of bankruptcy”, and devoted substantially all of my follow-up blog entry to explaining how arduous debt renegotiations are, and how therefore it’s not at all easy to extract value from them.

As for Pirrong’s proposed solutions, insofar as they destroy the anonymity of the markets, I think they’re highly impractical and will never be implemented. As for speeding up the CDS auction after a credit event, that does nothing to solve the problem at hand, which is how to avoid credit events in the first place by encouraging the full participation of bondholders in restructuring negotiations. Bondholders have discovered that if they hedge themselves in the CDS market, they can be lazy about such matters. And there aren’t any easy ways to get a lazy bondholder to do hard negotiating work.

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Comments
2 comments so far

I think you may be focusing on the wrong transaction costs. To pierce the Coasean retort, one must demonstrate that frictions exist to impede the unwinding of CDS and the transfer of bonds. Pirrong argues that if such transactions are efficient, then the perverse incentives that bond hedging via CDS create can be efficiently diffused.

That said, I’m not convinced that the bond and CDS markets are as well lubricated as Pirrong seems to suggest. To me, the enormity of the CDS market is as much evidence for the presence of significant CDS unwind costs as it is for the popularity of the instruments. If unwinding or novating CDS was so cheap, why did the aggregate notional amounts balloon to umpty-trillion bucks over the course of the past decade?

Felix:

Thanks for taking the time and thought to respond to my post. Re long–well, that’s nothing for me;-) I like to be thorough.

I am not at all persuaded by your response. Rather than responding in turn with a comment, I’ve done so on Streetwise Professor.

In a nutshell, I don’t think that your arguments address the crucial issue, which is what is the incremental contribution of CDS hedging to the lazy bondholder problem (to use your analogy). Many of your arguments are true of all distressed debtor situations, even when CDS are absent.

Anyways, thanks again, and perhaps this debate will continue.

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