Do We Hate Credit Default Swaps for The Wrong Reasons?

There's a lot of crazy ignorant hating on CDSs out there, especially from certain political journalists who displayed no interest in learning about the financial community until they found that pronouncing the words "credit default swaps" in a sneering tone made them seem extraordinarily wonky and profound, particularly to themselves.  Credit default swaps have been indicted in so many of our national ailments that I have begun to wonder if those people do not curse credit default swaps when they stub their toes or find that the milk jug is empty again.  Credit default swaps certainly caused AIG to fold, and they've undoubtedly made all manner of things worse, but giving them single-handed credit for the financial crisis is like blaming Italy for World War II.

But there are legitimate reasons to worry about the growth o the CDS markets, regulatory arbitrage first among them.  And now here's another possible reason:  they may be making it harder for firms to restructure short of bankruptcy:

This week, mall operator General Growth Partners (GGP) and newsprint maker AbitibiBowater both filed for bankruptcy, after failing to persuade bondholders to restructure voluntarily.

Now lawyers involved in these bankruptcy proceedings tell the Financial Times that the credit default swaps are the problem -- mainly, bondholders who have purchased CDS on this debt have little incentive to negotiate or play ball, since the CDS, if the counterparty honors the agreement, makes them whole.

. . .

If it is AIG [on the other end of the swap contracts], it means our bailout is pushing companies into bankruptcy that might otherwise be able to restructure.

Note that this has been alleged before, though previously with GM's ongoing failure to get its bondholders to exchange debt for equity. Now those involved in actual bankruptcies are citing it as a problem.

This is very troubling.  We know from mutliple economic studies that systems that are too creditor-friendly have lower rates of entrepreneurship and innovation.  We all have a vested interest in forcing creditors to the table short of liquidation (though to be fair, in this particular case, my sense is that the bankruptcy is expected to result in a reorganization, not a liquidation). Perhaps swap contracts should allow the issuers to get involved in these negotiations, the way insurance companies sit at the table during lawsuits.