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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12 comments so far

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Posted by GMhumor | Report as abusive

You’re argument ignores the presence of naked CDS holders…ie, investors that purchased CDS w/o owning bonds and that are clearly incented to drive GM to bankruptcy (to recover CDS protection value) or near (to sell the contracts and realize gain). CDS are OTCs so there could be tons of outstanding protection contracts.

Posted by CS | Report as abusive

“credit default swaps make bankruptcies more likely”

So, if an investor can’t insure himself with a CDS, and can’t expect that his loan to a company, which allows the company to continue or expand, will precede shareholders, etc., you honestly believe that investors won’t ask for higher yields going forward? You’re asking them to assume more risk than they bargained for, and yet that added risk won’t lead to higher interest.

I’m not going to loan money to anyone who wants me to assume more risk so that I can’t force them into bankruptcy if I determine that I can’t get my money back otherwise. Do you expect loans to be limited to family members?

The bonds are loans that allow a company to exist, expand, diversify, etc. Or am I wrong? But once I lend the money, adios to my wanting to get paid back. Wow.Makes sense.

As for CDSs on nothing, I guess, there has to be someone who sells it to me. That means that there is someone who sees things differently than me, and has no incentive in selling me a CDS that I can manipulate. I can’t declare CDSs and foist them on passersby.

“You’re argument ignores the presence of naked CDS holders…ie, investors that purchased CDS w/o owning bonds and that are clearly incented to drive GM to bankruptcy (to recover CDS protection value) or near (to sell the contracts and realize gain). CDS are OTCs so there could be tons of outstanding protection contracts.”

- Posted by CS

I believe you’re mixing up two different concepts. If you own the bonds, and have hedged by buying CDS contracts, unless you’re 100% hedged then there is a directional bias. Some investors may be fully hedged if they held illiquid bonds, could not sell them, and therefore bought insurace. But by that time the price of CDS insurance would have soared, so they would have bought bonds with comparatively low yields, and then hedged with expensive insurance, locking in a loss.

Secondly, you can buy a CDS without holding the underlying bonds. But the seller the of CDS will have to pay face value of the underlying bonds upon a credit event such as bankruptcy. So as the buyer you will be selling at par 100, and if you do not own the bonds buying them in the market for pennnies as bankruptcy looms inevitable. Clearly it is not a neutral outcome for you. But in the macro sense your gain is someone else’s loss. That is true.

However, the zero sum game theory breaks down when losses and gains are asymmetrical. Not all players that make losses can afford to make good on their promises. In the case of a bankruptcy where the seller of a CDS cannot make good on claims against is then there is a net loss period. You as the buyer of the CDS do not get your payoff. A loss to you. And the seller of protection defaults as well. Clearly a loss to him as well. Defaults and bankruptcy change the zero sum game fundamentally.

Posted by MrBill, Eurasia | Report as abusive

A holder of CDS has an incentive to promote a bankruptcy if his CDS holdings are larger than his bond holdings. For example, you may have a holder of $100 of bond debt and $1,000,000 of CDS. Please note that the amount of CDS outstanding can — and usually is — considerably larger than the actual amount of outstanding debt.

Posted by Rush Limbaugh | Report as abusive

Glad you put me straight on this one. Here I was thinking that what has driven GM into the ground was crap management not giving its customers what it wanted – smaller more efficient cars that lasted longer whilst simultaneously spending profligately on unnecessary areas.

But hey, what would I know, I am just a customer who won’t buy a big crappy gas guzzler that lasts 5 minutes before something goes wrong with it.

Once again just about everything is the fault of those dreadful bankers and absolutely no one else….yawn.

Posted by nick | Report as abusive

If the bondholders (protected by CDSs) had an incentive to push GM into bankrupcty, wouldn’t it be reflected in the current price of the CDS? If so, shouldn’t the bondholder be able to “capture” the profit on his/her CDS by reversing the transaction at current prices?

Posted by Brad Ford | Report as abusive

wrong, wrong and wrong in the comments.

The trade in question is called a ‘basis trade’. I buy a bond, and then I buy protection on that bond in the SAME amount by using CDS (lets say $10mm of each). They key here is that they don’t ‘cost’ the same amount. One of the major inefficiencies in the bond market that has resulted from the carnage of the last year+ has been the differnce in pricing (there are a lot of reasons why). This differnece is known as the ‘basis’. If/when GM defaults, I can use my bonds to close out my CDS position and capture the difference in pricing. If GM survives, then I dont capture the difference, and as people unwind the trade I probably lose money.

Posted by Bill | Report as abusive

Email me at if you own GM retail bonds to contact Retiree and Individual GM Bond Savers. We are prepared to demand equal treatment of GM’s creditors in court.

Posted by Jamie | Report as abusive

Don’t worry about those pesky bond holders. Even though they loaned money in good faith, they should be thankful for 10% of their investment.

Should the bond holders put the interest of millions of 401K owner before their “patriotic duty” to help the country there still is an option. Obama will declare the bond holders invalid and arbitrarilly force them to take the 10%. So what if it violates basic contract law?

Obama has a mandate and he will do anything he wants to push his agenda regardless if it is against the law.

Posted by jackoman | Report as abusive

I can’t believe the offer GM is giving people who had $70,000 or more invested in GM stock. CNN had a news story where a school teacher put most of her life’s savings into the stock under the assurance that the government was going to protect her money.

Here is an idea. Since GM is liquidating all their assets why not offer stock holders several cars in exchange for the amount of money they originally invested. Let’s see that would be 3 or 4 luxury cars or trucks. At least then they could sell or lease the automobiles and recoup their losses.

Just an idea for people like me who believed that when we invested into GM 6 years ago that this would never happen.

I think bankruptcy is the right way to go, but not the way the Administration wants it to go. It should be a disconcerting fact that in both the Chrysler and GM bankruptcies, the Administration is pushing senior bondholders to take well less than they are legally entitled. Secured creditors should be paid the full amount, according to the rule of absolute priority. Additionally, the UAW and government are getting the lion’s share.

I read a very good article with a humorous title, “Goodbye GM, Hello People’s Car” at 009/05/good-bye-gm-hello-peoples-car.htm l

My other great concern is that GM is going to be used as a policy tool and not as a private business. There have already been claims from the Administration that the focus is going to be on small, hybrid cars, while trucks and SUVs have the highest profit margins. Is Obama the new Clement Attlee?

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