As discussed above, when you buy protection, you (the protection
buyer) buy it from someone else (the protection seller) who will end up
paying out if a bankruptcy does indeed occur. These protection sellers
are very interested in making money, and so, as the probability of
default increases, the price of protection or "spread" widens, making
it more expensive to purchase protection. So, as firms get closer to a
restructuring or bankruptcy, the cost of buying CDS protection on
soon-to-be-junk bonds skyrockets. And not only does the cost of
protection go up, liquidity, or your ability to enter into CDS trades,
on distressed entities dries up. There's a fine reason for this too. As
the probability of default edges closer to certainty, fewer people are
willing to take the other side of the trade. They're just as convinced
as you are that ABC will fail, and they'll tell you to go sell your
bridge to someone else.
This means that in order to take advantage of the
restructuring-sabotage-strategy, you have to either (i) guess which
companies are doomed for failure well in advance of any real trouble;
or (ii) wait for trouble and then lay out a ton of cash and find
someone stupid enough to take the obviously wrong side of a bet with
you. Neither scenario seems likely to occur often, since (i) requires
some fairly remarkable foresight and (ii) requires remarkably stupid
counterparties. Moreover, in the case of (i), if you're truly convinced
that ABC is headed for restructuring or bankruptcy, you can buy
protection with "Restructuring" as a credit event, which means that if
ABC does restructure, you'll get paid. So, in that case, you don't have
to sabotage anything. You can just sit back and wait for an ABC
restructuring or ABC bankruptcy, since you'll get paid in either case.
Moreover, rather than waste all that time and effort trying to
sabotage a restructuring, you can cash in before a bankruptcy ever
occurs. As the spread widens beyond the point at which you bought in,
your end of the trade is "in the money," and so it already has
intrinsic value that you can realize in a variety of ways. For example,
assume that when you bought protection on ABC, the spread was 150 bps.
When rumors abound that ABC is entering talks with its bondholders, you
can be sure that the spread will be well above 150 bps. Let's say that
the spread widened to 1000 bps. As a protection buyer, your side of the
trade has economic value that you can realize by entering into another
trade in which you sell protection to someone else. (The CDS market has
recently begun changing the way CDS spreads are paid, but we'll assume
we're operating under the old system where the protection buyer pays
the spread in quarterly installments). That is, you sell protection at
1000 bps, pay for protection at 150 bps, and keep the remaining 850 bps
for yourself. Sure, you could go for the gold and sabotage a
restructuring, but that's a lot more involved than simply entering into
an offsetting trade and pocketing the juice.
In addition to the market based reasons above, there are corporate
governance reasons why we shouldn't coddle these kinds of claims. When
a company issues bonds, it includes terms that it and its bondholders
must live up to. That is, each bondholder could be asked to swear on a
stack of bibles that, "I will not go out and buy CDS protection to the
hilt and ruin you." If a company were truly concerned about the risk of
restructuring-sabotage, it would include such terms.
