SeekerBlog

Reliable source Economics of Contempt (whose proprietor is a structured finance lawyer with a background in economics), notes the delicious contradictions of those who blame the financial crisis on the “evil credit default swap”:

I love the logic of the anti-CDS crowd.

First, they claimed CDS were evil because protection buyers weren’t required to own the underlying bond—they were mostly used for pure “speculation” rather than hedging. The anti-CDS crowd frequently cited Eric Dinallo’s claim that 80% of CDS are held by investors who don’t own the underlying bond (“naked CDS”) as proof that CDS are evil.

Now that it’s fashionable to blame CDS for pushing companies into bankruptcy, they look at the net notional CDS outstanding on a company attempting a restructuring, and assume that 100% of them are held by bondholders. What happened to all the anger about naked CDS?

If the problem is that you can buy CDS without owning the bond being protected (gambling vs. legitimate hedging), then CDS should be a non-factor in restructurings. After all, aren’t 80% of CDS held by investors who don’t own the underlying bond? And wasn’t that supposedly the problem in the first place?

You can’t have it both ways.

[From 2 + 2 = CDS Are Evil!]

Do read the comments to this post as well. Here are two excerpted replies:

Economics of Contempt said…
archer,

I haven’t seen anyone making that argument. The standard argument is that a bondholder who owns a CDS on his bond will get paid 100 cents on the dollar in the event of a bankruptcy filing, so if the company offers him 60 cents in an out-of-court restructuring offer, the bondholder has an incentive to reject the restructuring. See, for example, here, here, here, here, and here.

As to your argument, the net notional CDS outstanding on GM is only $2.4bn, and there’s $27bn in GM bonds outstanding. So even if 100% of the CDS on GM is held by bondholders (extremely unlikely), they can’t have overhedged by enough to force a bankruptcy (it takes 10% of bondholders to reject the restructuring). The argument fares no better in Chrysler’s case, because we already know that 9 of the 20 holdout bondholders owned no CDS on Chrysler.
May 13, 2009 8:46 AM

Economics of Contempt said…
mattw,

jck is right. The net notional CDS outstanding on GM is only $2.4bn, and there’s $27bn in GM bonds outstanding. If 80% of the CDS on GM is held by investors who don’t own the underlying bond, then only $480 million of the $27bn in GM bonds (or 1.8%) are protected by CDS.

It’s been the same way with the other bankruptcies as well. The net notional CDS outstanding just isn’t that high.
May 13, 2009 9:07 AM