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Credit Default Swaps Behind Two Major Bankruptcies This Week; is GM Next?

The Financial Times (h/t Andrew Leonard at Salon) reports that credit default swaps were partial causes of two giant bankruptcies this week. Before CDSs became such a huge part of the financial world, there is a good chance that General Growth Properties (shopping centers) and Abitibi (paper) would have been able to work out a plan with their bondholders. Most bondholders probably realize that a breathing space without a bankruptcy might well be enough to allow these companies to recover.

Bondholders with CDS protection on their bonds, however, will be paid in full in the event of bankruptcy, so their interests are not the same as the unprotected bondholders. If there are enough protected bondholders, they can refuse to negotiate with the company, and force it into bankruptcy. At that point, the protection sellers have to pay off, and get the bonds in exchange, which allows them to participate in the bankruptcy, but it is too late. The giants are in the hands of the New York/Delaware bankruptcy lawyers guild, and the fee clock is ticking.

In December, I pointed out that CDSs were a problem for GM, because they concealed the identity of debtholders who would be affected by bankruptcy. According to the DTCC, there are 5,252 CDS contracts outstanding on GM, with a gross value of $38.4bn and an expected notional value of $2.68bn. According to the DTTC, the notional amount is the maximum amount of money that will change hands on the occurrence of an event of default, after netting and application of collateral. The total amount of GM bonds is about $29bn.

There is no doubt in my mind that the refusal of the bondholders to make a deal with GM is in part due to credit default swaps. The bondholders owning CDSs get paid off in the event of a bankruptcy. They don’t get paid off in the event of a restructuring. Why should they make a deal? Screw the workers. Screw the management. Screw everyone in sight. Isn’t that the function of credit default swaps? Isn’t that why financial elites love them and want to keep them?

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