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.”