Is credit default swap activism dangerous?

03 November 2020

By Andrea Gamba

When Pope Francis describes a financial product as “poisoning the health of the markets” you know there is a serious problem.

Indeed, credit default swaps (CDS) have been singled out by many as playing a significant role in precipitating the 2007-08 financial crisis and have been cited as a mitigating factor in the collapse of holiday giant Thomas Cook that saw more than 20,000 employees lose their jobs and 150,000 UK holidaymakers stranded abroad.

The Thomas Cook incident highlighted how CDS have evolved in the decade since the financial crisis from insurance to compensate creditors should a company default, to become the tool of a new form of activism.

And it is not just the UK-based holiday firm that has been caught up in the crossfire of CDS battles. In recent years others, such as clothes and homeware retailer Matalan, electronic goods store RadioShack and Norwegian paper producer Norske Skog have also fallen foul of CDS activism.

In fact, it is on the rise. The Commodity Futures Trading Commission (CFTC) found the first case occurred in 2006, with six more instances of CDS investors intervening in the next decade. But in a two-and-a-half year period up to 2019 there were 14 similar CDS strategies.

In the case of Thomas Cook, the UK-based firm was at the centre of a CDS tug of war. As it looked to put together a rescue package bondholders who had CDS in Thomas Cook threatened to vote against it unless their CDS contracts were paid as part of the plan as they would miss out on the money from the firm going bankrupt. But another large bondholder had issued the CDS and offered Thomas Cook £150 million to keep the holiday firm afloat so it did not pay out the CDS.

It was a catch-22 the company could not solve and went under seeing most - but not all because of a contract dispute - CDS owners being paid. It is this type of activism that has led for calls for CDS to be regulated or even banned and for Pope Francis to describe CDS as “continuously less acceptable from the perspective of ethics respectful of the truth and the common good, because it transforms them into a ticking time bomb ready sooner or later to explode, poisoning the health of the markets.”

But can a financial instrument that has been in existence since the 1990s and by 2018 had grown to $8 trillion of notional value outstanding, according to the Bank for International Settlements, really be that bad?

Well, no. My theoretical analysis alongside Andras Danis, of the Georgia Institute of Technology, shows that CDS help secure more investment for businesses, securing more jobs and creating value not destroying it, while also, partially at least, solving the ‘empty creditor’ problem.

The empty creditor problem was raised by Patrick Bolton and Martin Oehmke, of Columbia University, in 2011 and essentially argues that if an investor lends to a company and takes out a CDS they don’t care if that firm defaults or not as they will get paid in full, which actually increases the likelihood of bankruptcy.

The CDS then becomes a way to bet on a company’s default. Traders will buy CDS because they know they will pay out if a company is in financial trouble.

But we show through our model that there is another way of looking at this. With the insurance of CDS, the cost of borrowing for firms is reduced. This is because, if there is a restructuring of the debt, lenders know they will get a better deal as they have to get a bigger pay-off than the CDS contracts offer for the bailout to be agreed, ultimately decreasing the chance of strategic default by the borrower.

CDS activism by buyers and sellers has become more apparent since Bolton and Oehmke’s article. Investors endowed with CDS have intervened to push a company towards bankruptcy, while issuers of the derivatives have stepped in to stop that happening. A stark example is Norske Skog where Blackstone’s GSO Capital Partners and Cyrus Capital Partners put together a rescue package involving debt and equity for the ailing firm. Both had sold CDS protection on the firm’s debt so were eager not to pay out.

But investors like BlueCrest Capital Management, who had purchased CDS on the underlying firm, were not happy with the controversial scheme, with media commentators labelling it an abuse of power and the CFTC arguing it could be seen as market manipulation. Indeed, CFTC’s concern was that the intervention of the CDS dealer rescuing the firm, on the debt of which the CDS was written, makes the initial CDS rate an unreliable indicator of the riskiness of the firm.

And yet in this type of activism by CDS sellers it is adding value, as it is preventing a firm from going under and saving many jobs in the process. Indeed, our modelling reveals that everybody is better off in this scenario, including CDS buyers.

For a start, if creditors can readily access CDS then they will be prepared to lend more money to firms, who, with greater financial clout, can invest in more equipment, employees or innovations. Also, with more money invested in a company and with more protected lenders, the borrower is more likely to repay the debt rather than engage in a strategic default. In fact our model suggests the chances of the firm being allowed to become bankrupt are greatly reduced and the increase in money invested is substantial.

Next, with more CDS sold it will be more likely for the CDS sellers to intervene if default is threatened, because they want to avoid making big payments to the CDS buyers. Therefore, when the creditors are buying CDS they are, in effect, paying for the CDS sellers to bailout the troubled business, and they are not made worse off by the intervention of the seller. By allowing the intervention the value of the firm increases as well and the overall economy is better off.

The one caveat with our model is that it assumes symmetric information. That is, the number of CDS sellers and buyers is known by both sides, but in reality this information is not readily available, which may indeed have an effect on the fairness of the initial pricing of CDS. This is because an active CDS seller has an interest to intervene only if its stake in the firm’s default is large. Hence, a relatively large seller could disguise itself as small and sell overpriced CDS, as investors would not anticipate its intervention. Thus, we argue a more transparent CDS market might help to ensure that firms benefit from the value-enhancing effects of a CDS market.

One way of doing this, is similar to the stockmarket, where holdings above a certain threshold have to be reported to the regulatory authorities. A reporting requirement for CDS sellers could lead to cheaper contracts, fewer bankruptcies, more investment and higher firm value.

CDS activism is a new and controversial phenomenon with many detractors. But we have shown that regulators should be careful not to overreact and study the benefits of the CDS market. For, instead of helping firms caught in a CDS battle, they could inadvertently destroy value and leave many companies worse off.

Further reading:

Danis, Andras and Gamba, Andrea, Dark Knights: The Rise in Firm Intervention by CDS Investors (2019). WBS Finance Group Research Paper No. 265, Georgia Tech Scheller College of Business Research Paper No. 3479635, Available at SSRN: https://ssrn.com/abstract=3479635.

Danis, A. and Gamba, A. (2018) "The real effects of credit default swaps", Journal of Financial Economics, 127, 1, 51-76.

 

Andrea Gamba is Professor of Finance and lectures on Advanced Corporate Finance on the Executive MBA and Corporate Finance on MSc Finance.

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