Annihilate the Perverse Effect of CDS

A stable and sustainable economic and financial system should have few positive feedback loops, or as some call pro-cyclic factors. Unfortunately, finance by nature tends to be pro-cyclic, thus the saying about bankers lending out umbrella when it's not raining. So one must be especially watchful of positive feedback mechanism in finance.

One unintended consequence of CDS is exactly the disastrous positive feedback. Bond holders with CDS protection would rather push the company into bankruptcy, as demonstrated by Lehman and Chrysler.

The bankruptcy code, whether by conscious design or not, disincentivize stakeholders from forcing bankruptcy except as the last resort. It achieves this effect by prolonging the process of stakeholder recovery and increasing the cost. This encourages creditors and owners to try to work it out, even through Chapter 11. After all, even though bankruptcy is no moral evil, it's still better to avoid it.

However, CDS changed the game dynamics (to be exact, the change is a compound effect of bankruptcy code change of 2005, which is disastrous in retrospect, and CDS). If you own bond and buy corresponding amount of CDS with physical delivery, you'd want the company to go bankrupt as soon as it shows the first sign of trouble and the bond devalues. You get 100% back on CDS settlement. It's much sooner than the end of Chapter 11, and you get back not only much more than at the end of Chapter 11 but even much more than if you unload the bond right now.

Before you cry "head off CDS", however, please realize it's not necessary to dump the baby with the bath water. As I said many times here before, CDS is just a tool. If it's caused bad effects, blame the people who use the tool or how its use is regulated, not the tool itself.

Here's how to save the baby while dumping the bath water.

If a bond holder also owns CDS, then her economic interest in the debtor is reduced by the protected amount. In bankruptcy court, her say should be reduced accordingly. The hedged interest is transferred to the CDS seller, who could/should replace the hedged bond holder in bankruptcy court.

Simple as that. I'd also argue that a shareholder with option protection should be pro-rated in a similar fashion on shareholder meetings.

There're always complications. For example, a shareholder with CDS protection could be incentivized to drive down the company. Bankruptcy code reform alone will not be sufficient to cover all bases, nor should it be the only tool. But at least it's a good start.