Blaming CDS holders for a GM bankruptcy

By Felix Salmon
May 12, 2009

The FT leads with a bold headline today: “Credit insurance hampers GM restructuring”. But the story itself is puzzling:

Analysts say the chances the proposal will be accepted have been diminished by the large number of credit default swap (CDS) contracts written on GM’s debt.

Holders of such swaps would be paid in the event of a default – but would lose money if they agreed to restructure GM’s debt. For investors who own bonds and CDS, this could create an incentive to favour a bankruptcy filing.

According to the Depository Trust & Clearing Corporation, investors hold $34bn in CDS on GM. Once off-setting positions are considered, the DTCC estimates CDS holders would make a net profit of $2.4bn if GM were to default.

The opposition of 10 per cent of bondholders is enough to derail the proposal, which has already triggered protests from investors who argue it unfairly rewards the UAW at the expense of bondholders.

“You have every incentive not to agree,” said one bondholder, a large credit hedge fund. “You would be locking in a loss if you did. It isn’t only the ‘shark’ capital; it will be the mom and pop mutual funds who will oppose this deal. ”

I’m not an expert on how GM CDSs have been written, but I’m dubious when it comes to the implication here that this restructuring will in general not count as a credit event for CDS purposes.

In general, my argument is that if bondholders have hedged their position with CDS, then they don’t particularly care whether or not a company goes into bankruptcy, and therefore are unlikely to expend much effort when it comes to avoiding bankruptcy. Since the costs of bankruptcy are generally high, this is at the margin a bad thing.

The FT story, however, goes much further, and says that holders of GM CDS have an outright incentive to prefer bankruptcy to a restructuring, and will “make a net profit” of billions of dollars if that happens.

It’s an interesting use of the word “net”, since it ignores the fact that net profit of a CDS transaction is always zero, with protection sellers losing exactly as much as protection buyers gain. If the protection buyers really have an incentive to see GM go into bankruptcy, then the protection sellers have an equal and opposite incentive to buy up their bonds and vote the other way.

Of course, it’s all pretty moot: GM is inevitably going into BK, CDS or no CDS. And it’s conceivable that a GM bankruptcy, like the Chrysler bankruptcy, might even be a good thing. But that assumes that a GM bankruptcy will cut like Alexander through the Gordian knot of contracts and competing claims in a swift and clean manner. And the probability of that happening is surely slim, the best efforts of Steve Rattner notwithstanding.

So while I’m sympathetic to the idea that credit default swaps make bankruptcies more likely, I don’t frankly think they’re going to make all that much of a difference one way or the other when it comes to GM, especially given that a bankruptcy is sure to happen in any event.

Update: Stephen Lubben rides to my rescue to explain the nitty-gritty of why a restructuring would probably not be a credit event for these CDS.

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