Bo Peng

Annihilate the Perverse Effect of CDS on Bondholders

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.

Annihilate the Perverse Effect of CDS on Bondholders

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.

Annihilate the Perverse Effect of CDS on Bondholders

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.