Tuesday, May 12, 2009

2 + 2 = CDS Are Evil!

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.

14 comments:

archer said...

You are misrepresenting the logic, and anyone familiar with the issues can see it.

The bondholders would not have an incentive to block the bankruptcy filing unless they were net short. That means some of their CDS holdings are "naked".

In fact, the more likely scenario is that they bought CDS when GM bonds were trading much higher, and now have picked up a lesser (relative to the contract notional amount) of GM bonds at their current cheap price to vote for the bankruptcy.

If you are going to disagree with the CDS opponents, please make a real argument rather than mischaracterizing their views. It's intellectually dishonest and only discredits you.

mattw said...

Also, since there is no reason to think that the coverage of CDS's is limited to the number of bonds outstanding, you could have the bondholders fully covered and still have 80% owned by non-bondholders.

This post was not one of your more logical efforts.

jck said...

Well, actually the net outstanding notional CDS on GM is not even a tenth of the volume of bonds outstanding.
The CDS opponents aren't even familiar with the public, easily accessible facts, and are generally clueless, we saw that recently with the Chrysler bankruptcy, blaming CDS for the filing, impossible since there aren't any outstanding.

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.

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.

Anonymous said...

Given that we don't know the distribution of CDS holdings, how can you and jck be so sure that it's the net notional that matters here. I know that CDS supporters like to claim that the dealer banks have neutral positions in most if not all of their holdings, I just see how anyone, much less one of us blog bloviators, could actually know that this is true. If you can't substantiate your position, then you shouldn't make an argument that relies on the assumption that it is true.

Don said...

It is not gambling. If I believe that a company is being poorly run, then I can invest accordingly. If I believe that a company is overvalued, then I can invest accordingly. The idea that you can only invest on success is preposterous. You want the market to reflect the best information available. Period. If you don't, then you're going to encourage the overvaluation of stocks and bonds, which works for a while, but ends badly.

Frankly, even gambling is fine with me. In sports gambling, a hell of a lot of knowledge and expertise goes into it. The main problem with it is fixing the event, which is illegal.

I can understand why people don't like gambling, but I think that it should be legal. I don't ever gamble. However, I would short stocks or buy CDSs because they are investing, if I had secured the majority of my portfolio. It's riskier investing, not necessarily stupid investing. For most investing, stick with Graham, but a little investing on such risky picks is sensible, if you do the research and know what you're talking about.

If I buy a CDS or CDO, then someone had to sell it to me. That means that they see the future differently. That's how prices and worth are determined.

As for bondholders, actual bondholders hedging their investments, that's to decrease the risk of their losing money. Their losing their own money. They've loaned money to the company, or purchased the bond from someone who did. There was a huge story yesterday about how high interest rates on bonds issued on companies are hurting the recovery. You can only make them more expensive if you make them riskier. You're losing the war to win a battle. Good luck going forward.

Don the libertarian Democrat

Anonymous said...

Just to clarify:

not only naked CDS buyer would prefer bankruptcy, bondholders with 100% CDS protection would prefer bankruptcy too as it would avoid lengthy restructuring process and as their economic exposure is hedged (empty bondholder), bankruptcy offers a quick solution.

Anonymous said...

net notional CDS always outpaces bond notional. i don't know where you get your figures because its not something that is reported. any counterparty across the entire world can trade on GM so I would bet that there is substantially more CDS outstanding on a net or gross basis than bond notional because that is always the case. this is proved time and time again after defaults trigger the contingent leg of the trade which requires physical or cash settlement and almost everyone selects cash settlement because they don't own enough bonds and can't get enough bonds from the street to settle the trade. notionals outstanding in the CDS market is not a number that is possible to get because this is a product that is traded in the OTC market. you would have to also consider index and the numerous bespoke products (packaged derivatives - derivatives of derivatives).

mike said...

I was going in debt while I was waiting for my settlement. Thanks to jg wentworthcash for annuity. Now I get monthly payments to help me out with my bills.

Anonymous said...

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. annuity rates

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