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New Rule: Restrict Credit Default Swaps for Primary Creditors

In a recent New York Times op-ed, author William Cohan discussed one of the many perverse incentives available to primary creditors in today’s financial markets. The article highlights how, in recent years, hedge funds have been purchasing corporate debt issued by distressed companies, then amending the terms of those securities in order to force said company into bankruptcy. Now you are probably asking yourself, why would any investor want to lose money intentionally? The answer is because shortly after purchasing those securities, traders at the fund would secure a significantly larger net-short position through credit default swaps that pays out much more if the company defaults than if the company remains viable and services its corporate bond payments. And because the fund positions itself as the primary creditor by buying a majority share of the company's outstanding debt, they can amend the company’s repayment terms in such a way to all but guarantee a default on payment.

Let’s walk through an example. Assume Company A purchases Company B’s debt from a commercial bank that originated the securities. Upon purchasing the debt, Company A also purchases credit default swaps that secures ten times the total value of the debt outstanding. Since Company A would make more money by Company B defaulting, they look for ways to guarantee that outcome.

But how exactly can they accomplish that? Well there are a few ways. One, they could shorten the notes' repayment schedule, forcing Company B to set aside cash to service larger coupon payments rather than invest in future projects. This won’t cause Company B to default per say, but the swaps will increase in value as Company B’s interest expense begins draining their bottom line. Two, they could make the case that Company B has become too risky and restructure the loans so that Company B is forced to pay a higher interest rate than they can reasonably afford. Last, and surely most callous, they could call in the loan altogether, knowing B doesn't have enough cash on hand to pay back the principal.

Now as banal as it is to say, this isn’t great for our economy. Every bankruptcy renders an immediate and visceral impact on the local, and sometimes national, economy. Such events should be avoided at all costs and certainly shouldn't be the optimal investment outcome for asset managers who have used their wealth to take advantage of firms in distress. But these are not normal times. And with the progression of securitization, ethical gray areas have emerged between investors and corporate governors, allowing perverse incentives to materialize in many of today's financial markets.

This doesn’t mean there isn’t a policy solution to this problem. Legislators have the authority to pass laws prohibiting trades where creditors profit on principal-agent disconnects with their corresponding debtor. Regulators could provide a rules-based approach that gives assurance that a company in need of restructuring doesn’t fear its own creditor is acting against its best interests.

But before I go any further, I must say that I am a big proponent of credit default swaps. Such instruments provide a snapshot of the inner workings of a company; a view that was not available until their inception. They also allow investors to protect against downside risk on assets that typically can’t be shorted through traditional broker dealers.

But, as the market for insuring investment has become more profitable than actual investment, the CDS’s original function of protecting against downside risk has morphed into investors using them as weapons of corporate destruction.

So how do we fix this problem?

A simple solution would be to prohibit corporate debtors with a material interest in a given company from engaging in swaps trades that yield more profit from a corporate default than what is earned on the underlying security. For instance if a company has $20 million of GE corporate paper at 8% interest, they can’t hold short exposure that would return more than $20 million plus the annual rate of 8% interest when GE goes belly up.

The hard part would not be implementing such a rule, or even enforcing it. The challenge would be determining what asset threshold constitutes a “material interest.” If someone holds a 1% capital stake, they really don’t have the power to dictate a firm’s financing arrangements. But entities like Aurelius Capital Management that held nearly all of Windstream Holdings's (a telecom) outstanding debt, and used it to force Windstream into bankruptcy, do have such power.

So what should the threshold be? Is it a 5% stake? Is it 10%? That’s really not for me to say; I think it’s a question for regulators. But I am confident the Fed, SEC, and other regulators can provide an answer. One thing I can say is that corporate owners should be looking out for the best interests of the companies they own, not using financial instruments to ruin families, careers, and communities, all for the sake of financial gain.

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