Perverse Incentives

I've covered this ground before, but it's worth going over again. For all the supposed benefits of derivatives, few "experts" thought about the downside risks of slicing, dicing and repackaging risk into myriad forms, and then redistributing the synthetically-created monstrosities throughout the financial system, before the current crisis unfolded.

Even now, there seems to be a lack of understanding about the unintended consequences of transforming familiar risks into instruments with properties that most people find hard to get their arms around, let alone prepare for. In "CDS May Undermine Debt Governance - Law Professor," Reuters details some particularly unwelcome consequences of what Wall Street refers to as "financial engineering."

The explosive growth of derivatives has made it possible that holders of credit default swaps (CDS) could sabotage the interests of a company and its other debtholders, a U.S. professor told a conference this week.

"Empty creditors could undermine debt governance," Professor Henry T.C. Hu, professor of law in banking and finance at the University of Texas, told the annual meeting of the International Swaps and Derivatives Association (ISDA).

For example, a hedge fund or other investor could hold $200 million of a company's bonds but could also have bought protection against default in the CDS market for $500 million worth of the company's debt.

In that case, the investor stands to profit more from its swap position than it would lose from its bonds and may act to help push the company to fail, such as by opposing an out-of-court restructuring.

The issue is taking on greater significance as analysts and debt investors expect the rate of global bankruptcies to increase later in 2008 and 2009 from what have been historically low levels.

By debt governance, Hu refers to the creditor's control rights in credit agreements and under bankruptcy law.

"Both loan contracts and the (U.S.) Bankruptcy Code are premised on the assumption that creditors ... have an economic interest in the company's success and will behave accordingly," Hu and Professor Bernard Black wrote in a law review paper in January.

"Large-scale, hidden debt decoupling weakens our ability to rely on these assumptions."

DERIVATIVES DECOUPLING

The January paper extended the work of the two professors, who published a paper in 2006 that caused a stir in the media and the market by identifying the risk of "empty voting" by shareholders with holdings of equity derivatives.

"The derivatives revolution in finance has made it easy to decouple financial voting rights from economic ownership," Hu said at ISDA. "Decoupling of control rights can also occur on the debt side."

The notional value of outstanding CDS on a number of companies is many times higher than the value of underlying cash bonds.

For that reason, ISDA has devised an auction process to determine cash settlement of CDS contracts in the event of defaults. When U.S. autoparts company Delphi Corp defaulted in 2005 for example, the value of notional swaps on the company amounted to about $30 billion, 15 times its $2 billion in bonds.

David Mengle, ISDA head of research, questioned, however, whether in practice an investor would end up holding both bonds and protection for a distressed company.

When companies are distressed, buying a hedge requires an expensive payment up front and dealers may be reluctant to sell protection, Mengle said.

As for companies that are not yet distressed, investors are not likely to buy and hold both bonds and CDS in a consistent way, he added.

There is no requirement for creditors to disclose their derivatives holdings, so the extent that they may have different economic interests in companies is not known.

Hu said, however, that bankruptcy judges and lawyers have told him that his theory explains instances of odd behaviour they have observed in recent years.

"One bankruptcy judge described a recent case wherein a junior creditor complained of too high a valuation being assigned to the bankruptcy estate," the professors wrote in the January paper.

Debt decoupling is also playing a role in the U.S. housing crisis, Hu said.

When homeowners faced difficulty in the past, they could go to their lenders and try to negotiate waivers or modifications, but this is more difficult now that thousands of loans have been repackaged into portfolios, which have then been sold in pieces to investors.

"The President's Working Group is calling on the banks to modify the terms of home mortgages, but they don't have the right to do that," Hu said.

Comments

[Jes]

"Both loan contracts and the (U.S.) Bankruptcy Code are premised on the assumption that creditors ... have an economic interest in the company's success and will behave accordingly,"....yeah, well, we used to think that home loan borrowers would never walk away, either. I wonder how many more 'decouplings' out there are just waiting to bite us like this.

[FB]

I don't get it. In able to collect on a CDS, you need to surrender the bond of the failed company. What's the point in buying more CDS's than you have bonds for?

[FB]

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[roger pasa]

The whole dam set up is perverse.Economist invent 10.000 ways to explain what is really very simple prime example Alain Greenspsan.Business people like politicians will promise you the sky in order to extract the most out of you.examples:buy 2 get one free the more you buy the more you save get $250.00 value for 19.95 no closing cost no points we do it all for you because you are worthed you could call this economy (economy of the dishonest.)Sad fact millions of dummies buy into it.Madison Ave.does a heckuva job