The Manual of Ideas'  Instablog

Imagine that you have invested $10 million in the bonds of Company XYZ, a cyclical business that has just breached a covenant specified in their indenture.  The company needs your agreement to waive the covenant temporarily so as to avoid a damaging bankruptcy filing.

Most bondholders in this situation would waive the covenant, perhaps in exchange for an increase in the interest rate payable on the bonds or, if the company is in more serious distress, in exchange for free warrants to buy the common stock.

You would not really have an incentive to put the company into bankruptcy -- unless you sneakily also purchased so-called credit default swaps (CDS), which are essentially low-cost insurance contracts that pay off in the case of a specified event such as a bankruptcy filing.

You might have bought CDS on Company XYZ even after you knew of the covenant breach.  The price of the CDS had gone up somewhat after the covenant breach, but this does not bother you because you can still make 10x on your CDS "investment" if the company files for bankruptcy. 

What's neat about this hypethetical situation is that you have the power to put Company XYZ into bankruptcy by refusing to waive their covenant breach.  Even if you lose $10 million on your bond investment, your comparable investment in CDS might pay you $100 million when the company files for bankruptcy protection.

Not a bad position to be in -- and it's apparently perfectly legal.  Forget about the fact that you have "insider information" about what you will do with regard to the covenant breach -- the SEC doesn't care.  Forget about the fact that you will screw other bondholders and shareholders -- you're out for yourself.  Forget about the fact that the company's business will be harmed by a bankruptcy filing and employees will be fired -- who cares.  You stand to make a cool $100 million on your CDS, just by using your $10 million bond investment as the vehicle to getting there.

It's clear that the legality of this kind of scheme threatens the corporate bond market and invites market manipulation.  This is precisely what may have happened recently in the bankruptcy filing cases of AbitibiBowater (ABWTQ.PK) and General Motors (GM). To be clear, these companies might have gone bankrupt anyway, especially in the case of GM. But that's not the point.  The point is that there might have been bond holders of AbitibiBowater and General Motors who wanted the companies bankrupt because they had side deals with payoffs that were far sweeter than any potential return on their bond investment.  Those folks might have put the companies into bankruptcy even if the remaining bondholders had wanted to find a compromise solution.

Listen carefully to the recent comments of George Soros in this Bloomberg video.

Disclosure: No positions.