For frustrated investors looking to justify the ban of credit default swaps (CDS), look no further than last week’s corporate bankruptcies of Canadian newsprint producer AbitibiBowater Inc. (ABWTQ) and U.S. shopping center developer General Growth Properties Inc. (GGP).
In both of these cases, credit default swaps became an actual bankruptcy catalyst - for the first time ever.
In the lead-up to both bankruptcies, the lenders who had debt outstanding - who would have the right to vote on any reorganization - had hedged their debt through credit default swaps and so stood to benefit from the company’s bankruptcy. That made it very difficult for both companies to get the majorities they needed for debt reorganization, making bankruptcy inevitable.
The CDS holders were in the position of seeing a 1929-vintage stockbroker balanced on a window ledge, and yelling “Jump, jump” - while simultaneously taking bets on the result.
In the AbitibiBowater bankruptcy case, holders of credit default swaps played two key roles:
- They were spectators and potential litigants.
- And they were the generator of lawsuits.
Let’s consider the first point.
When AbitibiBowater missed a bond payment on March 20, there were a lot of CDS derivatives outstanding that were close to maturity. Holders of these securities wanted to have AbitibiBowater immediately declared in default so that they could collect - a delay would allow their credit default swaps to expire.
However, non-payment of bond obligations generally does not become an actual “default” for several days (because the company is given a few days to come up with the money). Moreover, AbitibiBowater obtained a court order allowing the bond payments to be suspended while the company completed its debt restructuring. Thus, the CDS holders (to a value of about $500 million) were out of luck.
Or were they?
An International Swaps and Derivatives Association (ISDA) ruling on March 28 allowed CDS holders (as of March 20) to claim payment through a cash-auction system, as if a default had actually occurred.
The second role that CDS holders played truly was analogous to sadistic spectators placing bets at a suicide. Bowater (which had merged with Abitibi in an over-leveraged deal just two years ago) wanted to exchange its 9% bonds in order to improve its cash flow and to remove the likelihood of bankruptcy. To do this, it needed 97% acceptance from holders of bonds maturing in 2009 and 2010.
