What a revolting develoment – lenders invest in CDS and pull the trigger

While lenders are living the life of Riley, the Financial Times reports this revolting development.

Credit default swaps, the derivatives instruments that have figured prominently in the global financial crisis, are now being blamed for playing a role in two bankruptcy filings this week.

Bankers and lawyers involved in restructuring efforts say they are concerned some lenders to troubled companies, such as newsprint producer AbitibiBowater and mall owner General Growth Properties, stand to benefit from a default because they also hold default swaps, which entitle them to payments in such events.

We have seen CDS becoming a significant factor” when negotiations on out-of-court restructurings fail, said Alan Kornberg, the partner in charge of the bankruptcy practice at Paul, Weiss, Rifkind, Wharton & Rice, speaking generally. “We used to talk about the practice theoretically but now we see cases where it is hard to get lenders to agree to tender or to compromise and then you find out that these holdouts had significant CDS protection.”

Abotibi, which filed for bankruptcy protection on Thursday, ran into trouble as the dire state of the newspaper industry eroded its cash flow and left it unable to service its debt load. It sought to persuade debt holders to exchange bonds due in August for new debt with longer dated maturity and higher yields, but failed to do so as creditors squabbled…

Such exchange offers require the support of a significant number of lenders, 97 per cent in the case of bondholders in this case. But those who withhold support often have powerful incentives to do so, either because they hope to be made whole or because they are seeking to force a filing that would trigger payments under their credit protection agreements, bankers and lawyers say.

Some creditors, including Citigroup, which held a small exposure to AbitibiBowater, hedged themselves in the CDS market, meaning their economic interest in the deal was different to lenders who had not bought credit insurance, according to people familiar with the matter. Citigroup declined to comment.

Lawyers say CDS holdings were also a factor in the default and filing for Chapter 11 protection of General Growth Properties this week. Restructuring advisers expect many more such cases involving so-called fallen angels, or firms originally investment grade, since CDS was widely sold on such names.

Will the  Bankruptcy court do a Digger O’dell on these lenders?  Only time will tell.

h/t CLS

3 thoughts on “What a revolting develoment – lenders invest in CDS and pull the trigger”

  1. If a storm damages my roof and I do not take reasonable action to limit the loss by covering the hole, moving valuable contents, etc., my insurer will only cover the original damage and not any portion of the loss that I reasonably could have avoided. The fact that my whole house is insured does not free me of responsibility to cut my losses.

    Why wouldn’t the holders of credit default swaps employ a similar standard? If full default could have been avoided by reworking the underlying assets, then the CDS guarantor should pay only the portion of the loss that would have been ceded in a reasonable attempt to cut the losses by refinancing the underlying assets.

    What we have here is another example of moral hazard but also an example of failure of the market and the lack of regulation to ensure that CDS are legitimately honest arms-length transactions. No insurer would pay a homeowner who refused to take reasonalbe steps to cut his losses, but I don’t see AIG or any of the other CDS issuers disputing the defaults where the investment banks and others have refused to cut their “swapped” losses.

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