Bloomberg Finds Conflicts of Interest in Debtland

Bloomberg News is excellent this morning looking at yet another problem caused by the giant, unregulated credit-default swaps market.

First of all, the wacky copy editors at BN get the headline of the day:

Darth Wall Street Destroying Debtors With Credit-Default Swaps

The story is about how investors are buying distressed companies’ debt and CDS betting against that debt at the same time—a so-called basis trade. Why? It’s an arbitrage play, taking advantage of price discrepancies in the two markets. Doing this can guarantee profits.

Nothing wrong with that. The problem is that this creates a huge conflict of interest by the arbs or hedges who now have incentive to let the company default. That’s the opposite of what bondholders normally want.

Investors who bet on the collapse of a company are pitting themselves against traditional debt holders at a time when Moody’s Investors Service projects defaults will more than triple this year and exceed the level during the Great Depression. The clash may stall restructuring efforts to prevent bankruptcies, as basis traders may be less inclined to participate in distressed debt exchanges, said Matthew Eagan, an investment manager at Boston-based Loomis Sayles & Co., with $7 billion in high-yield assets.

“Before, you really had to worry mostly about where you were in the” company’s capital structure, he said. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.”

In other words, the CDS market could cause internecine battles between bondholders, forcing companies to go bust that otherwise might have made it. In a devastated economy, that’s dangerous. It opens up a whole new can of worms at a time when added uncertainty is the last thing we need:

“You’re given these control rights under loan agreements or bond indentures on the general assumption that if you’re a creditor, you have an interest in the borrower surviving,” said Hu, who’s written about so-called empty creditors. “Because of things like credit-default swaps, that assumption no longer holds”…

“People are having a hard time trusting anyone,” said Timothy Coleman, co-head of the restructuring group at Blackstone Group LP in New York. “The motivations on the other side of the table are different.”

Bloomberg lists several companies who have been or are the targets of this CDS trade, including Ford Motor Company and Lyondell Chemical Company.

What’s missing from this story is an explanation of why there are such price discrepancies in these markets. Is it because the CDS markets are much more liquid than the debt markets? It quotes an analyst saying basis trades aren’t bad since they bring efficiency to markets. It should have explored that more.

Still, it’s a super interesting piece by Bloomberg and a great effort to shine a light on this dark corner where the roaches and rats are scurrying.

It looks like this is yet another downside of the Wild West world of credit-default swaps.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.