04 May Credit Default Swaps: The New “Bankruptcy Trigger”?
An earlier post on this blog covered the potential impact of credit default swaps (CDS’s) on distressed debt and suggested that
CDS’s could impede the negotiation of workouts, pre-arranged or pre-negotiated Chapter 11 plans, as creditors with a vested interest in the debtor’s failure either refuse to negotiate or – worse yet – actively seek the company’s demise.
A spate of recent articles in April indicates this is exactly what appears to be happening in the troubled auto industry – and elsewhere.
In a short April 17 piece, The Atlantic’s Megan McArdle cites to mall operator General Growth Partners (GGP) and newsprint maker AbitibiBowater as examples of recent Chapter 11 filers who – but for the credit protection provided lenders and bondholders by CDS’s – might have been able to negotiate consensual restructurings without the need for a court proceeding. Two other, more recent articles – one from the Detroit Free Press and another from The Deal – reference the same negotiation dynamic in talks surrounding proposed workouts for automakers General Motors and Chrysler. Readers will undoubtedly be aware that Chrysler commenced Chapter 11 proceedings last Thursday in New York. GM’s impending bankruptcy has been the subject of speculation for some time.
When a troubled business attempts to restructure its debt, how should its management address the “CDS effect?” Should CDS issuers be incorporated into the work-out discussion? Where the issuer is a counter-party on a number of “at-risk” CDS’s involving multiple troubled companies, should the issuer be allowed to fail so that lenders are instead required to deal directly with their debtors?
Ms. McArdle cites to earlier work – including a Financial Times article, and a Business Insider article tying the continued viability of some CDS protection to the AIG bailout (an earlier Business Insider piece went further, directly linking AIG-issued CDS’s to GM’s inability to reach terms with its lenders). She then goes on to argue that a bankruptcy system too creditor-friendly (i.e., one that permits lenders to rely upon third-party protection, rather than forcing them to the table with their debtors) discourages entrepreneurship, makes reorganization more difficult, and in the end, proves a societal disadvantage.
Now, wait a minute.
Wasn’t the AIG bail-out (which, in turn, “propped up” the viability of the CDS’s on which many lenders rely) itself really an attempted government-sponsored reorganization of sorts? If so, McArdle’s argument (and the articles she cites) leads to the conclusion that government intervention for the purpose of propping up the issuers of CDS’s ultimately leads to more corporate failure.
Can it be that government efforts to shore up the economy (or at least, to shore up the issuers of CDS’s) are, in fact, making it harder for businesses across a broad range of industries to negotiate their own restructuring?