Annihilate the Perverse Effect of CDS on Bondholders

A stable and sustainable economic and financial system should have few positive feedback loops, or as some call, pro-cyclic factors. Unfortunately, finance by nature tends to be pro-cyclic, thus the saying about bankers lending out umbrella when it's not raining. So one must be especially watchful of positive feedback mechanism in finance.

One unintended consequence of CDS is exactly the disastrous positive feedback. Bond holders with CDS protection would rather push the company into bankruptcy, as demonstrated by Lehman and Chrysler.

The bankruptcy code, whether by conscious design or not, disincentivizes stakeholders from forcing bankruptcy except as the last resort. It achieves this effect by prolonging the process of stakeholder recovery and increasing the cost. This encourages creditors and owners to try to work it out, even through Chapter 11. After all, even though bankruptcy is no moral evil, it's still better to avoid it.

However, CDS changed the game dynamics (to be exact, the change is a compound effect of bankruptcy code change of 2005, which is disastrous in retrospect, and CDS). If you own bond and buy corresponding amount of CDS with physical delivery, you'd want the company to go bankrupt as soon as it shows the first sign of trouble and the bond devalues. You get 100% back on CDS settlement. It's much sooner than the end of Chapter 11, and you get back not only much more than at the end of Chapter 11 but even much more than if you unload the bond right now.

Before you cry "head off CDS", however, please realize it's not necessary to dump the baby with the bath water. As I said many times here before, CDS is just a tool. If it's caused bad effects, blame the people who use the tool or how its use is regulated, not the tool itself.

Here's how to save the baby while dumping the bath water.

If a bond holder also owns CDS, then her economic interest in the debtor is reduced by the protected amount. In bankruptcy court, her say should be reduced accordingly. The hedged interest is transferred to the CDS seller, who could/should replace the hedged bond holder in bankruptcy court.

Simple as that. I'd also argue that a shareholder with option protection should be pro-rated in a similar fashion on shareholder meetings.

There're always complications. For example, a shareholder with CDS protection could be incentivized to drive down the company. Bankruptcy code reform alone will not be sufficient to cover all bases, nor should it be the only tool. But at least it's a good start.

Comments

[Jasper M:]

". . . even though bankruptcy is no moral evil . . . "
Not sure I can agree with that statement.

That said, the notion of reducing a bondholders take in bankruptcy court by the amount of his insurance strikes me as sensible.
Am I right? Anyone?

May 01 05:00 AM

[Livin' in t...:]

I couldn't agree more. However, there is so much that has to be reformed in the CDS market., In good conscience, we should not help those who sold these derivatives to honor their commitments until the playing field is level. For example, no more CDSs should be issued to a market place than debt outstanding. In the case of Bowater, it has been estimated 6 times the CDSs were issued than the debt it was covering. Since there is no rules to protect investor interests against the effects of CDSs, we should force the banks and insurance companies that offered them to negotiate how they honor payment on the CDSs, instead of hurting one class (retail investors) in favor of another larger class (institutions), and ultimately the US taxpayer. Instead maybe CDSs should have only been allowed to be built into the issue at the beginning of an offer, so all investors could participate in the protection in an equitable manner. Like municipals, the insurance would be reflected in lower yields, but bump the quality rating. Some believe that the current lack of regulation has a criminal element to it. All investors should be treated equally and given full disclosure. If many of us knew that these instruments were being used, we would have reconsidered investing in corporate debt in the first place.

May 01 06:55 AM

[Leftfield:]

Such a simple remedy makes me think it's unlikely Washington would pass it. Complexity seems their mode, to protect favored interests and hide the fact. To make deals within the complexity for ongoing paybacks. Think IRS.

May 01 10:07 AM

[shootpar2001:]

Now the entity standing in (issuer) does not want to pay the insurance and will vote the exact opposite.
What have we accomplished?
Without effective insurance; the bond buyer(s) will now demand a higher rate of return; we just raised interest rates.......thank you.



On May 01 05:00 AM Jasper M wrote:

> ". . . even though bankruptcy is no moral evil . . . "
> Not sure I can agree with that statement.
>
> That said, the notion of reducing a bondholders take in bankruptcy
> court by the amount of his insurance strikes me as sensible.
> Am I right? Anyone?

May 01 10:16 AM

[LKofScotland:]

He who hesitates is lost. If the "old" bankruptcy code was designed to prevent bankruptcy in the first place that's because bankruptcy in that time was the kiss of death and not just a "not necessarily immoral" condition. Today bankruptcy is not merely the kiss of death--it is death itself and reworking one's debt with a completely dysfunctional financial system is more than just a little scary. The technical term is "political" I believe. So, yeah--buy those CDS not because its "more efficient" but because it gets you to head of the "bankruptcy line" quicker. So long as the contracts are being honored there can be no great sales pitch for CDS than the past six months. We'll see how well the Obama administration's implementation of the Bush policies in this space will be. I must say I'm surprise that a conservative Republican even formulated a government response. To date the fact that the government is even doing something I regard as a success especially have seen the actual downward reaction which is no myth as Kudlow and Co. so openly are ignorant of. But does the government response even if successful equal a bullish case going forward? With the CDS product speading like Kudzu its hard not to declare the losers in this environment like the American GI on the Omaha Beach--dead before they even get out of the boat.

May 01 10:33 AM

[jpiretti:]

I agree with most of the article. My take on the CDS market is that it is an instrument that has a purpose, but I view it like I view naked short selling. A holder of a CDS contract should be required to hold the underlining security (hedged protection) as opposed to betting on liquidation. I hate to sound like a tin foil hat conspiracy nut case, but how many naked CDS contracts were held by investment firms that could exact pressure on companies to force them to liquidation purely for the profit of the contract?

May 01 11:08 AM

[Augustus:]

The CDS seller can own the bonds. Just buy them in when paying off the CDS contract.

May 01 11:57 AM

[Econ 101:]

Shine a light on the cockroaches, watch them scatter

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May 01 12:01 PM

[viewfromnyc:]

This concept is poorly conceived and based on incorrect premises. First if I am a bond holder with CDS protection, I want the company to pay the coupon as long as possible. Buying a bond and simply getting the principal back doesn't earn me any money. In fact I would lose money since I've paid the CDS premium. Therefore I really have no incentive to push the company into bankruptcy. Second as a bond holder, I have no power to force the company into bankrupcty unless the company defaults on its contractual obligations to pay principal and interest. Once that happens bondholders could file an involuntary bankruptcy petition.
Quite simply companies don't file for bankruptcy because their stock price declines or their bond prices decline. They file for bankruptcy because they cannot pay either their debt!

Limiting CDS purchases to bondholders is a solution proposed by people who do not understand financial markets. Just like any other market there are a variety of different participants, e.g. long term holders, short term traders, speculators, hdegers etc. If potential participants are not allowed to enter the market, the market for that instrument will be less liquid and therefore more expensive either as a result of wider spreads or lack of market depth. Commentators fail to consider the ramifications of that sort of proposal. For example if I bought a bond and CDS protection, what would happen if I sold the bond and the buyer decided that they didn't want to buy the hedge? I would end up long CDS on a bond I no longer own, should I have to sell it back to the bank (I wonder where the bid would be), should I have to keep paying the premium even though I no longer need the protection?

For this writers proposal, the question is why the CDS seller should get some of my recovery? If the CDS settles at 20 cents, my expected recovery in bankruptcy is 20 cents. If my claim is split with the CDS writer I would only get 4 cents (20% of 20 cents).

May 01 01:38 PM

[Bo Peng:]

viewfromnyc, I think you misunderstood what I was saying. I was not saying CDS seller should share the bond recovery. That would change the nature of the product. I was saying CDS seller takes on credit risk of the issuer while the buyer transfers out of the credit risk, therefore in bankruptcy court the bondholder's representation should reflect her real credit risk exposure after accounting for the hedge.

In normal times, bondholders of course would like to get coupon payments. In distressed situation, however, yield goes to 30% and bondholder is faced with the choice of taking the capital loss by selling on the secondary market or taking the significant default risk by holding on to the paper. In good'ol times, these are the only two choices. So she's very incentivized to help saving the company. Now she just buys CDS and, all of a sudden, bankruptcy becomes at worst a non-event, roughly equivalent to if the company spring back to health and bond goes back to par or if the company drags on in despair.

DIP financing used to be an important life saver for companies in Chapter 11. Shareholders used to aligned with the company. Now with hedging, people can have zero exposure, yet still retain their voting rights. This is absurd. Hedging is perfectly fine. It's the bankruptcy court and shareholder meetings that have fallen behind times and produced the absurdity.

May 01 04:54 PM

[viewfromnyc:]

The U.S. system gives a preference to rehabilitating the debtor in bankruptcy whereas other legal systems give preference to ensuring maximum recovery for creditors. As a creditor to a company my duty is to maximize the recovery. That may be accomplished by a liquidation or that may be accomplished by a restructuring of the debt and a continuation of the company as a going concern. The concept of "saving a company" is reaction to retain control usually by the stakeholders (management)who have destroyed it from overleverage and/or from failing to recognize and adapt to the changing business environment. Or from shareholders who failed to do research to understand the true business risk, overpaid and are likely to be wiped out anyway, think AIG, LEH, FED, DSL, Chrysler, GM. As a bondholder and a senior stakeholder, if I can put the approriate capital structure on an otherwise viable business, that would maximize my recovery (through equity ownership in the reorganized company) otherwise the assets need to be liquidated and transfered to others who will make productive use of them. If the assets are employed productively so too will the human capital of the business. The existence of CDS does not change any of this, in fact the a competent writer of CDS, like any option market maker probably hedged the credit exposure as it deteriorated through a short stock or short bond position anyway. The concept that the CDS holder assumes the credit risk and should have a stake is ridiculous. What would happen if the CDS buyer didn't own any bonds? The CDS takes a derivative risk but has no direct effect on the outcome and no influence, much like two friends betting on a sporting event or wagering on a horse race. In other scenarios, a distressed buyer could buy bonds at a steep discount then buy CDS after the credit improved to lock in the profit. Asymetries hurt markets.

Again until the company defaults, there is really nothing a bondholder can do to save the debtor, other than forgiving the debt. The company may make a debt for equity offer, buy back bonds on the open market, negotiate a prepackage plan of reorganization, but still the company controls its own fate.

CDS is a complex knock in option struck at par. As a bondholder, I would have to pay a premium to protect my position, once the credit quality of the issuer deteriorates that option becomes very expensive, so it would be cheaper to sell and realize the loss. The reason for creating the synthetic call is from a belief that the credit will recover. Options are not free. The same is true for equity options, if I have created a zero exposure postion in order to control voting rights, I have paid real money to do that. I have decomposed the value of the equity by separating the voting rights and compensated someone else who has the economic exposure for those rights. My interest as a shareholder or bondholder Seeking Alpha are not necessarily aligned with the other stakeholders of hte company, e.g. management and employees. As a shareholder, I want the company to take on maximum leverage and return capital to me either through buybacks or dividends. Most companies that borrow money to buy back stock are not doing so to insure the survival of the company but to maximize potential returns to share holders and shift risk to bondholders. The key for investors is not to whine and complain but to analyze the game theory to understand who profits and why.

May 02 01:02 PM

[Bo Peng:]

viewfromnyc, you're right that the US corporate law emphasizes more on shareholder than, say, the German system that gives bondholders more weight. I'm not advocating any change at the philosophical level. There's no duty for the bondholder to "help" the company. If only to respect your effort of writing such long comments, I'd like to avoid diverging into other directions.

What I am advocating is the simplest, most common-sensical remedy of the disassociation of the normal economic interest created by modern hedging techniques. No need to bring in naked CDS buying. It's a separate topic by itself. Let's reiterate:

Set-up: You hold $1M bond. Company is in trouble.

Scenario A: You're unhedged. You have $1M worth of say in re-org/restructuring/b... negotiations. No problem there.

Scenario B: You're fully hedged with CDS -- how much premium you pay for it is irrelevant. Now you have 0 exposure. In fact, given the fact that the company is in trouble, it's better for you if the company defaults right away than going through some other remedies. But you still have $1M say in the negotiations. Of course you'll push for speedy default. This is a problem. While bondholder is not expected to help the company, she's not expected to push the company off the cliff, either, not in a system that's rational on the macroscopic level. The old system was mostly rational. With CDS and the bankruptcy code reform of 2005, the last inhibition is taken out.

Compare LTCM and Lehman. Back when LTCM was in trouble, all Wall St banks had their skin in the game. They pitched in and helped orderly unwind. In the end, everybody won in the sense that the economic loss turned out to be much less than a brute force shutdown, and the shock to the financial system was much smaller. When Lehman was in deep water, however, bankruptcy reform of 2005 had been in place. Derivatives counterparties got to cash out even through Chapter 11 protection. Furthermore, most big Lehman bond holders are well protected with CDS. As a direct result of this new dymanics, no big institutions had the incentive to help Lehman avoid bankruptcy. The end reuslt is a disastrous shock to the system, and a lot of retail bondholders got wiped out of their life savings.

If there were no 2005 reform, the other Wall St banks would've been incentized to at least help Lehman unwind orderly, much like LTCM. If the bondholder netotiation power had been allocated by the real economic interest after accounting for hedging, which would shut out many of the institutional bondholders and bring in net Lehman CDS sellers, at least everybody's interests would've been much better aligned.

May 02 03:40 PM

[George Fiala:]

Looking at the 11 years since LTCM crash, maybe it would have been better to take the bitter medicine then rather than a smooth unwinding. The wrong lessons were learned and we've gone through two crises since, with this last one a doozy.

The problem of over-speculation is what should be focused upon, and unregulated CDS, especially naked, only contributes to speculation, not to investment in industry.

May 02 09:36 PM

[Bo Peng:]

George, I don't think the orderly unwinding of LTCM is the source of the problem. The problem is that Wall St learned from that lesson and lobbied hard for the bankruptcy code reform of 2005. They got their wishes, and became the wolves that devoured Bear, Lehman, and Merrill, and then went on life support themselves. You could almost call it poetic justice if the consequences weren't so dire and widespread.

May 03 06:15 AM

[Lilguy:]

You go, Bo!

May 03 09:51 PM

[Alexander V...:]

Chrysler's bondholders have pushed the company into bancruptcy,
because they thought, that they were offered too little money in the
settlement. Suppose, the CDS sellers were the ones, who would
decide to settle or not. Suppose, the CDS sellers would come to
the same conclusion as the bondholders, i.e. "too little money
in the settlement". Then, the CDS sellers would push the company
into bankruptcy, because the less money the bondholders get under the settlement, the more money the CDS sellers would pay to the bondholders. Nothing has changed in incentives.

May 03 11:33 PM