Why credit swaps encourage bankruptcy

From Mark Thoma:

As if credit default swaps needed any more bad press! The Financial Times' Henny Sender reports today that credit default swaps may have left two big-name companies with no other option than to declare bankruptcy this week, instead of concluding out-of-court restructuring deals with their debt holders.

Here's how it works: A lender buys the bonds of a company -- let's say General Growth, the huge mall operator that declared bankruptcy this week. But then, hoping to hedge against the risk that General Growth might default on its bond obligations, the lender purchases a credit default swap protecting against that event from another party, in effect buying insurance against the chance that those bonds will go bust.

But the kicker is that owning a credit default swap on General Growth bonds turns out to make the lender less willing to cut a deal that would allow General Growth to avoid bankruptcy, because the lender can get paid in full in the event of that bankruptcy by collecting on the insurance policy. So it's better for the lender to force the company to its knees rather than come to a less disastrous arrangement.

"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."

Warren Buffet was never so right as when he called derivatives "weapons of mass destruction." No matter which direction you point them, someone gets blown up.

Geithner plan is price discovery, but on an option with taxpayer guarantee, not on the legacy asset

Joseph Stiglitz, like Ulysses, Nouriel Roubini, Dean Baker, and others has apparently been named "Nobody." As in Nobody saw the collapse coming. "Nobody" predicted what is happening now. And so on. Perhaps even, "Nobody" has the answer.

Stiglitz captured the Geithner plan as well as anybody when he told Tom Keene at Bloomberg that it was an attempt at price discovery, but instead of the asset price, the process discovers the price of an option on the asset which involves a big guarantee of downside protection written by the taxpayer.

This is elementary. Attempts to finesse and end-run the reality are doomed to die in the Siberia of policy error. Only when we face facts will we get the financial sector fixed.

Something went wrong, Bernanke sez

This flash from Ben Bernanke last week:

"Something went wrong"

by way of Bloomberg and Mark Thoma's Economist's View Blog:

Federal Reserve Chairman Ben S. Bernanke said the collapse of U.S. lending will probably cause “long-lasting” damage to home prices, household wealth and borrowers’ credit scores.

“One would be forgiven for concluding that the assumed benefits of financial innovation are not all they were cracked up to be,” the Fed chairman said... “The damage from this turn in the credit cycle -- in terms of lost wealth, lost homes, and blemished credit histories -- is likely to be long-lasting.” ...

“Something went wrong,” Bernanke said. “We have come almost full circle with credit availability increasingly restricted for low- and moderate-income borrowers.” ...

Bernanke ought to have been content, but wasn't, and continued

"Regulation should not prevent innovation, rather it should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes," ... "We should be wary of complexity whose principal effect is to make the product or service more difficult to understand by its intended audience."

Innovation in financial instruments is proven to be inefficient and dangerous. The products and services of the real economy is where innovation ought to be concentrated. Bernanke is so far behind the curve he is still heading north while the economy is heading south.