naked capitalism

We’ve discussed before how credit default swaps, which is in essence insurance against the default of particular issuer or index, poses risks to the financial system via counterparty failure. The notional amount of CDS is $45 trillion, but much of that is believed to be fully or nearly fully hedged via offsetting positions. The problem is if some of those hedges turn out not to be effective due to a counterparty, such as an investment bank or hedge fund, taking a financial hit, you could see cascading losses as suddenly-exposed players try to exit or adjust positions.

But there is a more mundane, more likely way that CDS can cause mischief. A study by two University of Texas professors concludes that CDS contracts give creditors incentives to push wobbly companies into bankruptcy. From the Financial Times:

A boom in the use of derivatives is giving creditors strong incentives to push troubled companies into bankruptcy rather than help rescue them, according to new research and industry experts.

A study by academics Henry Hu and Bernard Black concludes that, thanks to explosive growth in credit derivatives, debt-holders such as banks and hedge funds have often more to gain if companies fail than if they survive. The study suggests this development could endanger the stability of the financial system.

The findings highlight a crucial problem in corporate restructuring when more and more companies are facing financial difficulties as a result of the credit crunch and US economic slowdown. According to the research and industry practitioners, creditors have a strong interest in voting against a restructuring plan if they have bought credit or loan default swaps, which trigger payments when a company fails.

“Investors now accumulate positions in a company by targeting layers of debt or multiple layers of debt,” said Michael Reilly of the financing restructuring practice at Bingham McCutchen.

“Where their interests lie are less predictable, especially if they also hold credit default swaps. Their financial interests may be best served by forcing a default if they are on the right side of a CDS position.” The problem is compounded by creditors not having to disclose derivatives positions, making it very difficult for companies and regulators to find out their real intentions.

The study by the two University of Texas academics warns that the breakdown in the relationship between creditors and debtors, which traditionally worked together to keep solvent companies out of bankruptcy, lowers the system’s ability to deal with a credit crunch.

“Spread across the economy, the ‘freezing’ of debtor-creditor relationships can increase systemic financial risk,” says the paper, which has been sent to the Securities and Exchange Commission. “[It] can also increase the economy’s exposure to liquidity shocks”.

Marcia Goldstein, chair of the Business, Finance & Restructuring department at Weil, Gotshal & Manges, one of the biggest corporate restructuring law firms, said anecdotal evidence suggested this was a growing problem regulators should address. She added that the current bankruptcy code and securities disclosure rules were inadequate to address the explosion in exotic securities that make it possible for sophisticated investors to cloak their true economic interest.