CDSs and Bankruptcy
Megan McArdle correctly notes today that much of the CDS-hatred out there comes from political pundits who are not — to put it charitably — particularlly knowledgable about or interested in law or finance. (“Credit default swaps certainly caused AIG to fold, and they’ve undoubtedly made all manner of things worse, but giving them single-handed credit for the financial crisis is like blaming Italy for World War II.”) She goes on to argue, however, that CDS’s may be having the perverse incentive of pushing firms into bankruptcy. The gist of the argument is that debtors have a harder time renegotiating debt with creditors who are protected by a CDS in the event of default, and this presents a systemic problem. I’m skeptical.
She’s shaky on the legal details, but I am assuming that there are terms in the CDS contracts whereby the protection seller is relieved of any obligation to pay the full value of the debt that is compromised by the creditor. It would certainly make sense to have such a term in the contract, as otherwise the protection seller would in effect be financing the restructuring of the over-leveraged firms whose debt they are insuring. She writes:
This is very troubling. We know from multiple economic studies that systems that are too creditor-friendly have lower rates of entrepreneurship and innovation. We all have a vested interest in forcing creditors to the table short of liquidation (though to be fair, in this particular case, my sense is that the bankruptcy is expected to result in a reorganization, not a liquidation). Perhaps swap contracts should allow the issuers to get involved in these negotiations, the way insurance companies sit at the table during lawsuits.
This is where I get a little bit confused. First, I reject the notion that a rule that forces a firm into bankruptcy is per se a pro-creditor rule. Indeed, the bankruptcy re-organization process itself is a pro-debtor system that allows firms to walk away from debt, retain assets, and pay their creditors only a fraction of what they are owed. Furthermore, I don’t see that there is any impediment right now to CDS issuers being in the room when the terms of an out-of-bankruptcy reorganization are negotiated. The issue is that they have limited incentives to do so. Forcing them to pay out under a protection agreement on debt compromised by the debtor and the creditor would, it seems to me, transform them from a provider of insurance to a provider of financing. They agreed to insure creditors against default, not to step in as what in some sense amounts to distress investors. A company, however, that can free up income and assets by avoiding debt because a third party will pay off the creditors gets a de facto infusion of cash from the third party.
If a company really wants to negotiate a restructuring outside of bankruptcy, it seems to me that they can still repudiate their debt, threatening to go into bankruptcy if the creditors pursue a judgement against them. The creditors could then collect under their CDS contracts, and if the CDS issuers have some sort of subrogation claim against the firm it seems to me that we are in exactly the position that we would have in a world of debtors and creditors with no CDSs.
At the end of the day, I think that there are all sorts of pathologies in the CDS markets — complexity, bad documentation, counter-party risk, short-squeeze problems, etc. Going forward I suspect that most of these problems will be solved by a clearing house system and burned investors who no longer want to sell a credit default swap on the default of a pool of collateralized Indonesian car loans denominated in Thai baht that was then indexed to a bundle of commodities, South American currencies, and the combined scoring averages of all of the teams in the NBA.
The danger to entrepreunership comes from punishing risk takers by holding unpayable debts over their heads in perpetuity. I am less convinced that requiring shaky firms to reorganize in bankruptcy or liquidate is such a bad thing.