CDS and the self-fulfilling default

Wall Street-made financial instruments purportedly created to protect investors against default actually hasten corporate bankruptcies, according to a new study. And it’s not Occupy protesters bashing these credit default swaps (CDS) –  the report comes from none other than the New York Society of Security Analysts. Its findings are as follows:

We present evidence that the probability of credit rating downgrade and the probability of bankruptcy both increase after the inception of CDS trading. […]

Lenders who insure themselves by buying CDS protection help push borrowers into bankruptcy, even though restructuring may be a better choice for the firm from the conventional (without CDS protection) lenders’ perspective.

The problem, say the authors, comes down to a basic conflict of interest – creditors holding the securities suddenly hold an actual stake in the firm’s failure.

CDS could affect bankruptcy risk through two channels associated with the empty creditor problem. The first and direct channel is the effect on the willingness to restructure the debt, whereby creditors (over)insured with CDS break the link between cash flow rights and control rights. Empty creditors are unwilling to restructure the firm even if doing so is efficient for debt value as they can profit significantly from their CDS positions. Several theoretical papers model the empty creditor issue.  […]

MF Global knows its former clients’ pain

Futures customers who smartly pulled their money out of failed MF Global Holdings Inc. in the weeks or months before the broker’s Oct. 31 collapse may not have escaped calamity after all.

As Reuters’ Jeanine Prezioso reports, some are worried the bankruptcy trustee could come after those funds to force them to share in any losses.

MF Global knows the feeling. It’s been there, and done that.

After futures broker Sentinel Management Group Inc failed in 2007, the trustee in that case, Frederick Grede, sued 50 of its former customers to recoup $600 million in funds withdrawn prior to the bankruptcy.

Murder, intrigue and the Beige Book

OK, so we’re a little geeky around here, but we just couldn’t resist sharing some of the juicy tidbits in the Federal Reserve’s Beige Book summary of economic activity.

We knew the economy was in bad shape, but thanks to the good people at the regional Fed banks we have now learned:

1. New York’s Broadway theaters saw a drop-off in demand starting in mid-October.