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Why Credit Default Swaps Interfere with Restructuring (and Why It Matters)

(photo: Adam T4)

(photo: Adam T4)

I speculated here that credit default swaps would make it difficult for GM to reorganize outside of bankruptcy. Other people agree that CDSs are a problem for out-of-court restructuring, including the Financial Times, George Soros, the Economist, and Professors Henry Hu and Bernard Black. The International Swaps and Derivatives Association (ISDA), the trade group for issuers of this stuff, has labored mightily, and brought forth a paper explaining that all those people, especially Hu and Black, are wrong.

This paper is in the same category as the notorious AHIP/PriceWaterhouseCoopers paper on the public option. The industry is trying to kill regulation, because banksters are making tons of money off their unsophisticated clients. Intellectual dishonesty is a tool in this struggle.

The claim of Professors Hu and Black is that bondholders protected by a CDS have different interests than unprotected bondholders. An unprotected bondholder only cares about whether the debt is worth more in or out of bankruptcy. For the protected bondholder, the issue is whether to hold out for a credit event, like bankruptcy, which will force the CDS counterparty to pay off the face amount of the debt. Other factors include whether there is a market for the CDS at that point, one with buyers, so that it might be better to sell the CDS and/or the debt instrument or both. These factors are beyond the economic question of the value of the debt. There is every reason to think it may be more profitable to force a bankruptcy than to participate in a workout, even if the workout is more profitable for the non-protected bondholder.

The ISDA paper doesn’t address the possibility of differing interests. Instead, it argues that there is no evidence that the existence of CDSs affects the number of out-of-court restructurings as compared to bankruptcy restructurings. One of its arguments is that in an 18-month period between 2008 and mid-2009, 11 companies were able to complete restructurings even though there were CDSs protecting their debt.

The paper doesn’t explain how this fact supports the argument. The restructurings were done by tender offer for a portion of the debt at distressed prices. The restructuring company offers to buy the debt at much less than a dollar for a dollar in debt, sometimes as little as $.20 on the dollar. They don’t insist on buying the entire issue, just a part of it. Tender offers like these might well have succeeded whether or not the tendering debt holders had CDSs. They provide no useful information about whether the factors deemed important by CDS holders would be different from those of unprotected debt holders. In fact, it isn’t clear how anyone would know whether CDSs affected any investment decision, because no one knows for certain who actually has them.

The ISDA paper is an example of one of the fallacies Nassim Nicholas Taleb describes in The Black Swan, which he calls the Ludic Fallacy. Casinos put most of their risk management efforts into catching cheaters, who aren’t likely to be able to make huge dents in their profits. It turns out that the real risks to casinos are outside the gambling tables. Taleb explains that four of the largest casino losses came from a) the injury to star performer Roy of Siegfried and Roy, b) an unhinged contractor who tried to blow up a casino, c) a clerk who failed to file important tax papers, and d) the kidnapping of the daughter of the owner, which caused him to dip into the till in an illegal way to raise ransom money.

The ISDA paper ignores the Ludic Fallacy. It assumes that all of the risks can be identified by looking at a single market. Wrong. No one can predict the interactions of multiple markets, multiple trading strategies, the different motivations of the players, and the impact of real world events. Nor can anyone predict what new interactions players can use to try to make money. The problem can’t be solved with smart people or big computers. It’s too complicated, and there are too many unknowns.

The ISDA paper doesn’t discuss the failed General Motors efforts to get an out-of-court settlement. Did I mention intellectual dishonesty?

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