An item on Bloomberg News has pushed me into a reluctant conclusion: credit default swaps (CDS) do more harm than good. We need to find the quickest way to eliminate them without inflicting greater harm. I’m not saying that process will be easy or neat. Only essential. And yes, a proper unwinding of CDS trades would take time. Also, banning CDS would mean that the United States would void previously lawful private contracts, something I am not exactly eager to advocate. But as the Naked Capitalism blog has pointed out at least once in its excellent discussions on CDS, we have done lots of things like this under emergency conditions. I would say our economy is at least approaching an emergency condition now.
Credit default swaps are contracts that insure the CDS owner against the default or bankruptcy of another entity. Under usual CDS terms you buy protection on $10 million worth of bonds for five years and pay an annual percentage of the insured amount as an insurance premium that is in the low single digits, or in the case of a strong credit, even less than one percent. If however the market begins to worry about a given credit, CDS premiums rise, or in the extreme case, CDS trade on an “upfront” basis, in which CDS protection sellers demand payment upfront for the whole five year term. On some CDS, sellers of CDS protection are required to start posting collateral in the event that the insured credit begins weakening (AIG got into trouble this way). If you own CDS on a bond you get paid at par, less the recovery value determined at auction when it is determined that the bond has experienced an event of default. If there is no default, you have paid out your premiums over the years and have presumably bought only some piece of mind with your insurance premium.
Here’s the rub. As Bloomberg notes, bondholders of some weak companies who own CDS protection now have every incentive to push the company to file for bankruptcy rather than work with them to keep the company alive. That stands proper economic incentives on their head in two ways.
First, before the advent of CDS, smart bond investors had every incentive to do good credit analysis on corporate bonds. In other words, they were paid to do their homework and avoid weak credits or sell their holdings of bonds of companies that had weakened. Now you have every incentive to buy weak bonds before everyone else realizes they are weak, assuming you can find someone to write CDS protection on them, because if the company goes bankrupt you are going to be made whole, as Bloomberg reports. Or, you buy distressed bonds along with the associated CDS, and depending on the price of the combo trade, you can still make money on subsequent price changes or what you receive in recovery after an event of default is declared. It’s now called, “the basis trade.” So now you have dumb bond buyers not bothering to do their homework because they expect insurers to bail them out — and smart bond buyers sometimes buying weak credits because they can get bailed out, too. Both of which distort the bond pricing system which should give us clues about which companies are sound and which are not.
Secondly, society benefits when lenders work with borrowers to prevent bankruptcies. That incentive is now being seriously eroded by CDS. Of course some companies are badly managed, overly leveraged, or have poor business models. Those companies should fail, that’s capitalism. The overleveraged ones with good business models should go through reorganization and come out as viable employers — that is the point of Chapter 11. The rest may have to be left to their fate. The point is, we want lenders to be patient with borrowers while we determine which companies would benefit from Chapter 11, which are hopeless, and which just might turn around without going through bankruptcy in the first place.
The basis trade also throws a new wrinkle into the profession of credit analysis for distressed bonds, Bloomberg reports. Now you have to go beyond valuing the bonds in the event bankruptcy for recovery value, and start learning who owns CDS, because holders of bonds and CDS might do even better by forcing bankruptcy rather than trading bonds based on intrinsic value.
As a daytrader I normally detest the idea of government restricting people’s opportunity to trade. But this might be one of the very rare cases where traders are overplaying their hand by exacerbating the weakness of an economy that is one step from Depression. If some day the boys and girls on some New York bond desk push Ford Motor over the edge into bankruptcy, do you think the rest of us traders will escape retribution when unemployed autoworkers figure that out? Good luck to us.