“Darth Wall Street Thwarting Debtors With Credit Swaps” by Harrington & Salas Essay

Mesdames Harrington and Salas, in their article, entitled Darth Wall Street Thwarting Debtors with Credit Swaps (Update2), have demonstrated the concept of unintended consequences. They highlight the negative and counter-productive results of the creation and proliferation of credit default swaps and negative basis trades (Harrington & Salas, 2009, pp. 1-5).

The entire system of bankruptcy procedure has, in living memory, at least, and to the eyes of the non-professional observer, been oriented towards preventing bankruptcy. It has been assumed, although not necessarily articulated explicitly, that the company’s employees, board, operational management, and stakeholders, all share a burning desire to keep the entity afloat indefinitely. This has been the case for individuals as well as corporations. Social shame, loss of credibility, the inconvenience and uncertainty of ever getting credit again, all have, historically, militated against declaring bankruptcy unless the situation became truly dire. The depressing realization that one must start all over again to rebuild a business, whether personal or corporate, has also acted as a powerful discouragement to taking any route which could lead to bankruptcy.

However, as Salas and Harrington explain, with credit default swaps and negative basis trades, the whole set of motivators changes. As they quote Henry Hu, describing what he terms, ‘Empty Creditors’,

“You’re given these control rights under loan agreements or bond indentures on the general assumption that if you’re a creditor, you have an interest in the borrower surviving,…Because of things like credit-default swaps, that assumption no longer holds.” (Harrington & Salas, 2009, p. 2)

This means that because the holder of a credit-default swap will earn something, no matter whether the fixed income instrument, which they also have an interest in, actually pays in full or not. The credit-default swap is, in the words of Investopedia, “A swap designed to transfer the credit exposure of fixed income products between parties.” (n.a., 2010) Salas and Harrington point out that, “Credit swaps were created by JPMorgan Chase & Co. more than a decade ago to hedge against losses from bank loans.” (Harrington & Salas, 2009, p. 3)

As with most risk management instruments, by whatever nomenclature they are known, this exotic hothouse flower of a derivative pays off most handsomely to the seller when the risk or peril is not incurred. Just as with life insurance, the seller hopes that the bond (or other fixed income instrument) will mature, as planned, pay, as planned, and thereby obviate the need for any laying off of risk.

However, the situation is different for the buyer of the Credit Default Swap. The buyer of a CDS is now “insured” against default. If, as Salas and Harrington put it, quoting Henry Hu, ““Say you’ve lent $100 million to a company and you had bought $100 million in credit-default swaps,” said Henry Hu, a law professor at the University of Texas in Austin. “In that circumstance, the creditor really doesn’t care whether or not the company goes under.” (Harrington & Salas, 2009, p. 2)

The value of the credit-default swaps, under the circumstances described above, if they are invoked, is close to the full value of the bond (and of course, the bond was purchased at some discount from its face value). Thus, if the bond matures, the holder profits by the implicit interest rate generated by the discounted purchase value, paid by the issuer. If the bond issuer defaults, the holder who has purchased a CDS gets some or all of that value, instead, from the seller of the CDS.

Then there is a further bit of arcane embodied by the negative basis trade. Basis is, in the words of Investopedia,

“the difference between the spot (cash) price of a commodity, and its future’s price (derivative). [In] the credit derivatives market…basis represents the difference in spread between credit default swaps (CDS) and bonds for the same debt issuer and with similar, if not exactly equal maturities. In the credit derivatives market, basis can be positive or negative. A negative basis means that the CDS spread is smaller than the bond spread.” (Brown, 2010)

Brown goes on to note that a negative basis trade is based on a derivative (the CDS). Brown describes this process as follows: “buying protection means you have the right to sell the bond at par value to the seller of protection in the event of default or another negative credit event.” (Brown, 2010)

Salas and Harrington point out that this current situation, wherein many investors are insured either way, seems to offer investors what would be termed, in the health insurance field, a perverse incentive to allow, or even push, companies over the edge into failure. This is explicitly foreseen by Matthew Eagan, whom Salas and Harrington quote as saying, “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.” (Harrington & Salas, 2009, p. 1)

These derivative instruments nonetheless have their admirers. They offer investors what Salas and Harrington quote Brian Yelvington as describing as, “a measure of efficiency to the market that didn’t exist during earlier recessions”. Yelvington asserts that the derivatives allow investors to place bets where they could not, in the pre-derivative past. (Harrington & Salas, 2009, p. 3)

Truth, the old saw says, is the daughter of time, and in the case of CDS and negative basis trades, the offspring is going to be very interesting. Our industrial giants may topple from the mere withholding of investor permission to retire debt. On the other hand, these instruments may perform a winnowing function which leaves only the strongest and cleverest companies standing.

Bibliography

Brown, M. (2010). Get Positive Results With Negative Basis Trades. Web.

Harrington, S. D., & Salas, C. (2009). Darth Wall Street Thwarting Debtors With Credit Swaps (Update2). Web.

n.a. (2010). Credit Default Swap (CDS). Web.