CDS II: To Fix Credit Default Swaps, Fix The Underlying Debt

by: Kurt Dew

Failures of the CDS market have become an almost daily occurrence.

But the omnipresence of CDS transactions in these market donnybrooks masks the fact that it is usually acts of debt issuers that create the market disruptions.

The response that would improve debt markets most is to create an exchange for fixed income risk managers – dominated by the buy-side but including like minded others.

Such an exchange would have self-regulatory status. Not only could this exchange improve market structure but could also list and police an exchange-traded CDS.

The most important problems of the debt market are being laid at the feet of Credit Default Swaps (see my earlier article, CDS I, for example, CDS problems). But these market disasters are not flaws of the CDS markets themselves, but problems with the debt underlying CDS. The remedy for the problems of CDS lies in altering the balance of power in the market for the debt underlying CDS to reduce the potential for abuse by CDS writers and buyers colluding with debt issuers.

More importantly, debtholders would benefit more generally from a class of debt that is less susceptible to issuer foibles including untoward market issues only tangentially related to CDS, such as the illiquidity of the debt market (look here for an earlier discussion of the effect of debt market illiquidity on LIBOR).

A market that prioritizes the needs of debtholders has the incentive to minimize the impact of issuer-generated problems. Importantly issuers of debt might also benefit from a class of debt that is less dependent on individual issuers’ circumstances. By buying individual issues and issuing a single diversified instrument with more risk manager-friendly properties, a portfolio manager could produce a one-stop shop for debtholder friendly issues.

A debtholder-friendly marketplace could protect both CDS traders and debtholders from corporate issuers’ unexpected decisions that favor either CDS buyers or sellers. To reinforce this result, debtholder market management might also list CDS for its debtholder-friendly issues, providing this marketplace with SRO standing for these particular CDS.

CDS are viable when written on more liquid debt, independent of issuer manipulation

CDS written on ordinary garden-variety debt fails where stock options succeed for two reasons. First, original issue debt reflects the negative effect of the fundamental difference between the responsibilities of corporate issuers to holders of common stock and corporate debt. Stockholders have leverage with corporate management, including the right to replace them; debtholders do not. This puts a very different face on the attitude of corporate management toward holders of the two obligations.

Indeed, acting in the best interest of shareholders, within the law, is a legal obligation of corporate management. As a result, the value of a firm’s corporate stock is rarely, if ever, intentionally damaged through a public decision of corporate management. Common stock is, in this sense, a buyer-friendly financial instrument.

The market for corporate debt is far less buyer-friendly. Indeed, arguably management must undertake any legal corporate decision that benefits stockholders at debtholders’ expense.

There is a single moment in time when debtholder rights are on a par with stockholder rights – the moment at which the firm sells the debt to the public. At that moment, the interests of stockholders align with those of debtholders, since both benefit from the sale of the debt at the maximum price the market will bear. But issuers inevitably add more covenants to a new issue than necessary in order to maximize the issue value of the debt. These unnecessary covenants increase the likelihood of a technical default (that is, a failure to meet the terms of the debt agreement that does not concern existing debtholders). But for debt that has an associated CDS market, such technical defaults can become an opportunity for clever traders to buy enough CDS and underlying debt to profit from a forced default (see Windstream Holdings Inc. (WIN) vs. Aurelius Capital Management in CDS I).

However, once a corporation issues its debt, bondholders are hostage to stockholders’ interests. Debt issuers colluding with either CDS sellers or buyers, long after the debt was issued, created the first two CDS market failures described by CDS I. In the first example, the existence of CDS caused the issuing firm to repay the debt it otherwise would have left outstanding, benefiting CDS writers at the expense of buyers. In the second example, the existence of CDS incentivized a corporation to consider default it would have avoided, expecting compensation from CDS buyers.

Thus, the first order of business for debtholder-friendly debt is creating debt that issuers cannot easily manipulate at debtholders’ expense. The debtholders’ marketplace might meet this objective by normalizing the terms of fixed income instruments listed there. Covenant-lite issues would minimize unanticipated defaults provoked by CDS buyers. If the CDS itself were listed on the same exchange as the newly created instruments, the exchange, acting as SRO, could police this negative behavior as well.

Issuer-independent instruments would be even better.

However, what of the third situation in the previous article? In the case of Windstream Holdings Inc. vs. Aurelius Capital Management, neither Windstream itself nor a majority of their debtholders thought it was in their interest for Windstream’s default to lead to bankruptcy. However, Aurelius won a lawsuit forcing a filing of bankruptcy by Windstream. How could debtholders reform the debt market to prevent this unfortunate outcome?

It would be most desirable for debtholders to list and trade a fixed income instrument immune from issuer blunders and other decisions that work against the interest of debtholders. An exchange could achieve this goal by constructing a diversified portfolio of very short-term debt of ordinary corporate issuers, managed by a fund that uses daily mark-to-market methods to assure the debt is market valued. The exchange could then list the new issue, providing buyers with a new debtholder-friendly fixed income instrument. One methodology for doing this is found here.

With the creation of fixed income instruments based on a diversified portfolio of individual debt issues bought and sold daily to preserve the objectives that exchange management pursues, the effect of individual debt covenants could be minimized. In addition, the risk properties of the exchange-originated instrument would meet the needs of risk managers more precisely, producing liquidity superior to that of existing quirky debt.

Putting risk managers on the front foot

Today debt issuers dominate debt markets at the expense of debtholders. Why? Holders of debt are not effective advocates of their important contribution to the market because they have created no sympathetic forum.

To balance the weight of issuer self-interest in determining market performance, a forum that represents the interests of both parties, on an even playing field, along with the concerns of the broker/dealers and traders who provide liquidity to the market, would go far toward remedying the problems of CDS discussed in CDS I.

What would a debtholders’ exchange look like?

A debtholders’ exchange would have the power to design both a debtholder-friendly marketplace and the debtholder-friendly financial instruments traded there. How would a debtholders’ exchange look different from a stock exchange? A debtholders’ exchange might seek several objectives:

  • Debt instruments that conform more closely to the requirements of debtholders – traders that use debt as a tool of risk management. In other words, one function of a debtholders’ exchange would be the issuance of debt with debtholder-friendly terms. This would require the capacity to transform existing issuer-friendly debt into holder-friendly debt.
  • Debtholders would seek two types of instruments: instruments that make deferred payments to align with debtholder obligations in a deferral accounting environment, but also similar instruments that may be marked to market in cash for use in a mark-to-market environment.
  • Markets with greater liquidity than existing debt markets. To make debt markets liquid, it would be necessary to reduce the number of issuers and simultaneously to increase the size of traded issues. In other words, a debtholder-friendly marketplace would issue instruments with value supported by multiple corporate issues. This suggests that an appointed portfolio manager would create traded issues from many issuer-dominated debt instruments. This would simultaneously reduce the new instruments’ idiosyncratic risks, generating greater liquidity.

Follow-on benefits to issuers

Importantly issuers, acting as individuals, sometimes make decisions that are counter to the global interests of issuers more generally. As decision after decision of individual companies damages the collective confidence of debtholders in the reliability of the value of particular debt issues, the inevitable effect is to throw a cloud over the market as a whole. This is certainly in no market participant’s interest.

The solution is for debtholders to form an association that represents risk managers’ self-interest and undertakes to change market practices accordingly. If debtholders successfully protected their interests as a group, debtholders would promote more than their own self-interest. They would promote the success of the market for debt as a whole – because their efforts would lead to both lower interest rates and larger quantities of debt sold. In addition, debtholders would benefit from a market self-regulatory organization. But one with sharp teeth. And one that settles extra-legal disputes. An exchange managed by debt risk managers and other like-minded organizations would fill the bill.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.