Floyd Norris praises the SEC for hiring University of Texas law professor Henry Hu. Norris likes this hire because Hu "was the first one [he] saw to point out that credit [default] swaps could be used to leave a creditor hoping that a company would go into bankruptcy." I sincerely hope that's not true (seeing as Norris is the NYT's chief financial correspondent), but I'm afraid it probably is. Apparently this is Hu's reputation—Felix Salmon calls him "the intellectual father of the CDS-help-cause-bankruptcies meme." Another academic who's evidently viewed as being prescient on the issue of CDS and restructurings is Stephen Lubben, who blogs at Credit Slips. Lubben has even referred to himself as "the professor that cried CDS."

This is highly amusing because Professors Hu and Lubben each observed for the first time that CDS could make creditors less willing to agree to out-of-court restructurings in the summer of 2007, which was at least 5 years after the first time CDS actually did have this effect on a major restructuring. How either one of these professors can be considered "prescient" on this issue is beyond me. Academia truly is its own little world.

People (and professors, apparently) seem to forget that CDS were around in the 2001 recession too. Clearly the blogosphere—as well as the NYT's chief financial correspondent—could benefit from a quick history lesson, so here goes.

Off the top of my head, the first major restructuring that I can remember being significantly hindered by CDS was Marconi, and that was back in 2001-2002. Marconi was negotiating a restructuring with a bank syndicate, but for a long time certain syndicate participants (cough, UBS, cough cough) refused to agree to any restructuring that didn't constitute a "credit event" under the 1999 ISDA Credit Derivatives Definitions. The holdout banks had purchased CDS on Marconi to hedge their exposure, and if they were going to agree to a pretty drastic restructuring, they wanted to make sure they got the benefit of their hedges. After more than a year of restructuring negotiations, the banks agreed to a debt-for-equity swap that qualified as a credit event under most of the CDS contracts, but also pretty much wiped out shareholders.

Mirant Corp.'s 2003 bankruptcy was also largely a result of CDS. Several creditors had purchased CDS protection on Mirant, and one major creditor in particular, which rhymes with Pitigroup, was relatively open about the fact that it didn't agree to a restructuring because it needed a bankruptcy filing to trigger its CDS contracts referencing Mirant. The bank that rhymes with Pitigroup's refusal to agree to a restructuring (which came at the last minute and was a big surprise, if I remember correctly) effectively torpedoed any chance Mirant had of avoiding bankruptcy.

The Marconi and Mirant restructurings weren't minor events by any means, and they also weren't the only restructurings hindered by CDS (just the first two that popped into my head). The trade press was littered with articles in 2003-2004 about how CDS were hindering restructurings.

The FT ran an article in 2004—almost 3 years before Professors Hu and Lubben began theorizing about CDS and restructurings—under the headline, Restructuring at risk from CDSs. The article read:

The rapidly expanding market for credit derivatives threatens to make it more difficult and more costly to rescue companies that get into trouble, restructuring specialists have warned.

This is because credit default swaps (CDSs), the most popular credit derivative, detach risk exposure from ownership and bring new and frequently inexperienced participants to the negotiating table.

"They are raising problems because of the way they divide ownership from risk of loss," said Richard Nevins, a restructuring specialist at Jefferies, an investment bank. "They produce perverse incentives for creditors to frustrate a successful restructuring because they get more from failure."
Coming out of the 2001 recessionary cycle, an industry group made up of bankers and lawyers (INSOL) conducted a lengthy study on the impact of credit derivatives on restructuring and bankruptcy. The result was a 65-page report, published in 2006, called Credit Derivatives in Restructurings: A Guidance Booklet. The purpose of the report was described in the executive summary:
Some concerns have been expressed that the presence of credit derivatives will make restructurings more difficult, and there have been reports that problems have already arisen from time to time, but it has not been established how often they have arisen.
...
The purpose of this booklet is to raise awareness of the potential impact of credit derivatives – in particular credit default swaps – on restructurings (including possible changes in behavioural dynamics resulting from positions in credit derivatives of participants around the restructuring table) and to provide a point of reference for those involved in restructurings facing situations where participants may hold such a position.
The INSOL report, which was well over a year in the making, was still published a year before Professors Hu and Lubben first observed that CDS could possibly change the incentives of creditors in restructuring negotiations.

Given that history, it's fair to say that I'm less excited than Floyd Norris about the SEC's decision to hire Professor Hu. If the SEC wants real experts on staff, it should start trying to attract experienced market practitioners. Pure academics are much cheaper, of course, but pretty much everyone in the financial industry agrees that for the SEC to be an effective regulator, it has to start competing for talent.

UPDATE: An anonymous commenter points out that The Economist ran an article on the Marconi workout, and the broader effect that credit derivatives were having on restructuring, way back in 2003. Some highlights from the article:
Marconi's case is a good example of the growing complexity of corporate workouts. No longer is it only company executives and their bankers that sit round a table rescheduling loans. Others also have seats, including investors who bought loans and bonds at a discount, and those who have bought credit-default swaps—insurance against a company's going bust.

The old, straightforward clash between a company and its creditors has been replaced by a mish-mash of interests. ... The holder of a credit default swap might prefer the company to go into bankruptcy. More complicated still, some around the table may be trading in and out of their positions each day, with their motives changing accordingly.
...
Those leading the restructuring could only speculate about the motives of some people at the table. There was great uncertainty over whether credit-default swaps had been triggered (in fact, they never were) [ed: actually, yes, they were]. Some banks seemed keen for Marconi to die, which suggested that they had credit insurance.
The article also casually makes reference to CDS affecting another workout at the time, which just underscores how much this issue was common knowledge even back in 2003:
Meanwhile, workouts are getting no easier. Only this week a Swiss company was taken to the brink of bankruptcy by maverick bank behaviour: credit derivatives were the suspected cause.
Remember, this article was published over 4 years before Hu and Lubben first started their "pioneering" work theorizing about CDS and restructuring/bankruptcy.

10 comments:

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Anonymous said...

First, thanks for this post, it's what I come to this blog for.

Secondly, I have a question (of sorts). I find myself unsure exactly why CDS has changed the bankruptcy process so much. Weren't there myriad ways to hedge before? For instance, buying calls on competitors who would win if the company went down, or just shorting the stock of the company?

Thanks for your time.

csissoko said...

I second Anon's comment. Extremely valuable information.

In some ways I think that what you are complaining about is how great the distance is between academic work and practitioner's experience. Lubben actually states "The financial community is unquestionably aware of the problem." His goal is just to bring it to the attention of legal scholars.

I actually looked up the Mirant bankruptcy a year ago and found no hint of this issue. So much of the trade press is behind a firewall that the details that seem so obvious to you are not necessarily in the public domain. Thank you for your post.

Economics of Contempt said...

Anon,

You're right that there were myriad ways to hedge already, but there was no real way to directly hedge credit risk before CDS. The reason CDS have changed the restructuring/bankruptcy process so much is that CDS are specifically designed to hedge the risk of a debtor filing for bankruptcy. Especially back when most CDS were uncollateralized, the entire payout on CDS trades was often contingent on whether the reference company filed for bankruptcy (assuming Restructuring wasn't included as a credit event).

Buying calls on a competitor, for example, is a much less precise way of hedging the risk of a debtor filing for bankruptcy, because the value of the call depends on a lot more than just the risk that the debtor will file for bankruptcy (e.g., all the competitor's own idiosyncratic business risks). Because CDS are specifically designed to hedge the risk of bankruptcy, creditors are much more likely to have purchased CDS on a distressed debtor. If enough creditors have hedged using CDS, and they all need a bankruptcy filing to collect on the CDS contracts, then restructuring negotiations are pointless, because too many creditors stand to profit from the debtor's bankruptcy filing to make an out-of-court restructuring feasible.

Economics of Contempt said...

csissoko,

Thanks. I didn't realize the stories about Mirant were all behind firewalls.

I don't have anything against Lubben per se. I'm mostly just amused by how many people -- journalists in particular -- automatically assume that academics are the leading experts in their fields.

Anonymous said...

At the time, the actions of those long prot on Marconi were actually highighted in an article in the Economist, so it wasn't exactly a well-kept secret! Perhaps the Economist is too low-brow for the academics to bother reading.

csissoko said...

For reference:
http://www.economist.com/finance/displaystory.cfm?story_id=E1_TSRTPPJ

hkke said...

Stories about Mirant were not behind firewalls. I teach a course on corporate restructuring and looking back at my lecture notes and my syllabus, I covered the Mirant case along with the role of the CDS that "Pitibank" held on the restructuring in class on September 16, 2004. I suppose that puts my class ahead of FT article. Too bad I did not publish it at a refereed journal though.

Anonymous said...

There are some suggestions in the public record regarding protection buying by Mirant creditors and its potential effect on the Mirant bankruptcy. See Jay M. Goffman, Mark McDermott & Andrew Thau, DISTRESSED INVESTING: SELECTED TOPICS, at 16 nn.92, 95 and 96 (2007), available at http://www.abiworld.org/committees/newsletters/financebank/vol4num3/materials/Distressed_Investing.pdf.

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