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Thursday, March 5, 2009

Basis Traders Rooting for Bankruptcies

“Say you’ve lent $100 million to a company and you had bought $100 million in credit-default swaps. In that circumstance, the creditor really doesn’t care whether or not the company goes under.” -Henry Hu

Basis traders have been successfully arbitraging bonds and credit defaults swaps. The downside is that the ideal outcome for a basis trader is actual bankruptcy. This is pitting shareholders, bondholders... errr... EVERY OTHER STAKEHOLDER against these basis traders. Interestingly enough, it seems the basis traders have the upper hand in the battle because they can sit and wait, while the other stakeholders cannot.

Talk about epic battle to the death.

General Electric (GE) for example is clearly caught in the crosshairs of this trade and is just one of many wounded enterprises currently being sniped... (More here.)

NOTE: Before you all rage at the injustice make damn sure you note that these traders did NOT put these companies into their respective situations. The companies did that all by themselves through their reckless behavior. Economic turbo Darwinism ain't pretty, but it is absolutely necessary.

Darth Wall Street Thwarting Debtors With Credit Swaps (Update2) : "Amusement-park operator Six Flags Inc. and automaker Ford Motor Co. may be pushed toward bankruptcy by bondholders trying to profit from credit-default swaps that protect against losses on their high-yield debt.

By employing a so-called negative-basis trade, investors could buy Six Flags bonds at 20.5 cents on the dollar and credit- default swaps at 71 cents. If the New York-based chain defaults, the creditors would receive the face value of the debt, minus costs. In a Feb. 27 note, Citigroup Inc.’s high-yield strategists put that profit at 6 percentage points, or $600,000 on a $10 million purchase.

Investors who bet on the collapse of a company are pitting themselves against traditional debt holders at a time when Moody’s Investors Service projects defaults will more than triple this year to the worst level since the Great Depression. The clash may stall restructuring efforts to prevent bankruptcies, as basis traders may be less inclined to participate in distressed debt exchanges, said Matthew Eagan, an investment manager at Boston-based Loomis Sayles & Co., with $7 billion in high-yield assets.

“Before, you really had to worry mostly about where you were in the” company’s capital structure, he said. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.”

23 comments:

Irrational Doomsday Blog said...

Oh snap, that's exactly the story I've been locked into for the last few days, and why I've been trying to figure out what the CDS clearinghouse or whatever regulation they eventually throw in is going to do to that trade and the overall market.

I think policymakers' decisions on CDS regulation are going to be the market movers...as usual, I never have any clue how it will all shake out though.

Anonymous said...

I wouldn't debate the "justice" ... the CDS holders are pursuing their rights, and the companies were mismanaged ... but I can't help but see this as another dubious aspect of the CDS innovation leading to perverse incentives and outcomes.

Anonymous said...

Ben,

Are the CDS writers going to be able to pay? My understanding is that many of them, like AIG, may be poorly reserved.

SS

Anonymous said...

on what basis are 'CDS holders' pursuing legal actions? breach of contract?

Pizza Dude said...

My thoughts...the CDS are worthless anyway because there is not one company that can cover. So what is the point? Investors driving bankruptcy to collect on obviously worthless paper? You might get that panic in about a week if these become more and more the norm.


In another way of looking at it the CDS's are creating short selling situations ....right?

Drop some science on me!

Pizzadude

Anonymous said...

isn't is "Baisse" instead of "Basis"?

Anonymous said...

Is this any different than taking out an insurance policy on a strangers' life and then rooting for the person's death?
Unregulated insurance upon the interests of others? Something otherwise forbidden (with good reason) for centuries?

Irrational Doomsday Blog said...

"My thoughts...the CDS are worthless anyway because there is not one company that can cover."

You cover by hedging your CDS bet. This is why there's so much action in really low strike value puts and stock shorts nowadays.

All of that puts downward pressure on stocks and borrowing costs, and the lower the prices go, the more this can self-reinforce, creating a self-fulfilling prophesy.

Companies that show any weakness (which is almost everything, or will be soon) are subject to "Economic turbo Darwinism" as the FN puts it.

Anonymous said...

Ahh....2+2 DOES =4.

And the policy makers don't like it!

lineup32 said...

the economy rewards speculation the CDS circus and stock market shows reflect what American industrial energy produces.

Anonymous said...

Bond holders that are protected by CDS should loose their ability to vote during any restructuring process. Their economic interest is protected by the hedge. Other stake holders, like unhedged creditors, employees, management, communities, should have a greater say in the structuring.

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