Felix Salmon and I are usually on the same side of the jury box when it comes to the trial of credit default swaps. However, it appears we have reached an impasse concerning creditor control rights in the context of restructurings and bankruptcies. While that sounds like an awfully narrow issue to quibble about, the policy implications of this seemingly obscure issue are far reaching and call into question both the orderly functioning of the debt markets and the soundness of the current bankruptcy regime.
Let's begin by outlining the issue at hand. In my previous article, I wrote:
Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC's bankruptcy. The problem seems obvious: B either doesn't care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.
In fairness to Felix, here's his added qualification of the issue from his response to my article:
The problem is a bit more subtle than that, and is simply that bondholders who have bought CDS protection have much less incentive to participate in restructuring negotiations.
The key to understanding why we shouldn't expect this change in incentives to lead to any material change in the restructuring process is rooted in the distinction between incentive to act and power to act. Clearly, anyone who expects to profit more from option A than B will choose A given the chance. And so, a bondholder who expects to receive a larger payout from CDS than from a restructuring will choose the CDS payout given the chance. But does that bondholder have any power to bring this result about? As a general matter, probably not.