In my first (and to date only) substantive post, I argued that derivatives in general and CDS in particular are misunderstood and unfairly maligned. That’s still true, I believe. But on further contemplation, I find that there is a fundamental problem with the classical argument in defense of certain derivatives.
Let’s start with CDS.
Megan McArdle at The Atlantic brings the issue to our attention by asking whether credit hedges (effected with CDS) are “making it harder for [debtors] to restructure short of bankruptcy.” Charles Davi (also writing at The Atlantic) and Felix Salmon at Reuters have both weighed in.
Davi succinctly restates the argument, which I’ll crib:
Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC’s bankruptcy. The problem seems obvious: B either doesn’t care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.
Davi goes on to perform a tear-down of this agrument by demonstrating the barriers to executing a nefarious “sabotage” strategy. For me, his tear-down is unsuccessful.
For one, he get’s the math wrong. He correclty points out that many CDS trade with some form of restructuring. What this means is that a Credit Event (as defined in the CDS agreement) is broadly scoped to include certain types of debt restructuring. Thus, when an entity restructures its debt, the CDS will settle and the protection buyer will deliver bonds with a face value equal to the CDS notional amount in exchange for cash equal to the full notional amount. [Note: I’ve described physical settlment; cash settlement is merely the net exchange of the difference between the notional amount and the FV of the restructured debt.]
However, Davi follows this fact to the wrong conclusion. Davi:
Assuming that [the investor has used a restructuring-inclusive CDS], … the hedged creditor is either indifferent towards or, in the case he’s over-hedged, has an incentive to see the Restructuring succeed.
This is demonstrably false. If the bond investor has overhedged, the incentive remains to see the restructuring fail, even if his CDS includes restructuring. Consider the following example:
I take as a given in this hypothetical example that the restructuring would be economically advantageous to all unhedged stakeholders. That is, let:
- R(bankruptcy) = Bond value in bankruptcy per 100 face = recovery upon bankruptcy
- R(restructuring) = Bond value in restructuring 100 face = recovery upon restructuring
- R(restructuring) > R(bankruptcy) [i.e., advantageous restructuring]
- CDS Notional > Bond Position [i.e., overhedged]
The investor’s total payout (CDS and bond) upon restructuring (assuming CDS counterparty performance) would be:
(1) CDS Notional/100 * (100 - R(restructuring)) + Bond Position/100 * R(restructuring)
…and his payout upon bankruptcy would be:
(2) CDS Notional/100 * (100 - R(bankruptcy)) + Bond Position/100 * R(bankruptcy)
Given the above assumptions, the investor would have an economic incentive to see the restructuring fail, not succeed. That said, the presence of restructuring terms in the CDS would cetrainly dampen the incentive.
But this is a quibble. The problem as I see it is much more fundamental and far-reaching than whether a slick hedge fund manager can buy significant positions in certain bonds, overhedge all of them (no-restructuring style, if he’s ballsy), and lay in wait for the opportunity to play saboteur if and when some of his debtors get into hot water. While such behavior would certainly be distateful, it is merely a possible symptom of a much broader problem. The problem is hedging itself.
More on that in Part II.