Thursday, April 30, 2009

CDSs Part 3: Hitting the Jackpot with a GM Bankruptcy

If GM declares chapter 11 bankruptcy, debt holders may actually be the big winners. Here is some background:

Bucking the trend, GM's imminent bankruptcy will likely create financial ripples from Main Street back to Wall Street. While a bankruptcy will arguably be good for viability and vitality of the company itself (it's a 100 year old has-been saddled with billions of dollars worth of decades-old moribund capital infrastructure and entitlement expenditures, in dire need of a "new beginning") it will be negative to a host of others including, but lot limited to:

a) semi-skilled, high school educated UAW workers with decades-long expectations of earning MBA or PhD level incomes
b) stock holders who have already seen their investments plummet 91% in just the last year (who will then see it plummet an incremental 100%)
c) executives at GM whose compensations were ceremonially set to $1 on the condition that if they could turn the company around they could stand to earn tens or hundreds of millions (if they could avoid bankruptcy).
d) creditors and bondholders who didn't have any form of bankruptcy insurance.

Creditors and bondholders who did have some form of bankruptcy insurance, on the other hand, just won the jackpot.

Oh yes, I’m talking about credit default swaps. That $39 Trillion butt-hole of a derivative that keeps popping its head up whenever a company goes bankrupt. Keep in mind that when CDSs were being invented just 10 years ago, the world economy was at the beginning of its 8-year winning streak. CDSs were an insurance policy against the ever-so-miniscule chance that any legitimate company could ever go bankrupt.
Brokers, dealers, traders, and other financial ‘innovators' had no interest in scenario planning against “what are the implications of CDSs in a recessionary environment,” because by the time such a reality presented itself, they would be long gone, living back in their suburban Main Street high school home towns in the big 6 bedroom track house with 3 cars and a trust fund for their two children.

Had such financial innovators scenario planned about CDSs in a recessionary environment, and had they any financial stake in such a possibility, they may have put safeguards into the systems. Such as (in the context of GM):

1) If GM goes bankrupt, just those debt holders who actually own the debt can buy CDSs to cover their position.
2) If the wife, neighbors or golf buddy of debt holder wants to get some of that CDS insurance coverage on GM too, they can’t. They can’t because they don’t own the debt. That would be silly. That would be like this author getting a life insurance policy on Fidel Castro or any other random citizen of this planet.
3) Likewise, if a GM debt holder wants to cover their position with a CDS, they can’t double, triple, quadruple, or quintuple their insurance coverage (as in, “I just lost $1 million when GM went bankrupt, but it’s all good because AIG just paid me $300 million on my GM credit default swaps when it went bankrupt.”)

Here are a couple of broken scenarios that may play out in the next couple of months:
GM will declare bankruptcy – a quick and clean bankruptcy that will clean off its books and kick-start it into the new century (because they are seriously stuck in the 1990s). --> Many bond-holders will feign disappointment at the hand they had been given, but secretly they will be giddy that they hit the jackpot. Their debt had been worthless for years by now, but the insurance on that debt is golden! --> Financial repercussions as AIG (you and me), Merrill Lynch (Bank of America), Barclays, and Morgan Stanley start paying out billions of dollars in CDSs. What next? It gets fuzzy since the banks are already teetering on the brink of collapse and that risk is mostly baked into their current market value ... so "how much" of a shock this will be to them is unclear. The US government may demand that anyone due to receive cash from an AIG CDS take a percent of the money due. But that may result in hefty lawsuits from an eager cadre of lawyers who haven't been doing too well in these difficult economic times either.

I digress ... at any rate, be on the lookout for people getting excited at a GM bankruptcy, because they just won the jackpot. I just said that in a really long roundabout way.


Dani Trimble said...

I am taking a class on derivatives and credit default swaps this summer... but until then I really have nothing to comment. On a related note, I just got my formal acceptance to Evergreen State. In a few months I will be driving more than half of the way to Tacoma every day...

Pastor Bob said...

Interesting, Rob. Congrats Dani!