GM and Credit Default Swaps

Don’t you wish you’d never heard about credit default swaps? I do. Somehow they have become inextricably linked in my mind with AIG and our great financial crash. Now I bet that GM also wished the darned things would go away.

Lenders buy credit default swaps to insure themselves against loss when a company they have lent to defaults on its loan obligations. To my ear that sounds a lot like an effort to avoid taking risk, while at the same time benefitting from the profits that risk taking bestow upon lenders. But that’s another story.

GM’s problem stems from the fact that many, if not all, its various creditors have purchased CDS protection against the possibility that it might default on its debt. Which, of course, it would do were it to enter bankruptcy.

Now, GM, as we know, is hurtling towards bankruptcy as we speak. It might well touch down there by the end of this month. If we are to believe all the dire pronouncements coming from its CFO and CEO they would like to enter bankruptcy soon so they can restructure the company and thus have a shot at survival in the new harsh world that will be the auto industry post recession.

In order to restructure GM has drawn up a plan similar in many ways to that of Chrysler. It involves securing government money to fund the restructuring, extracting concessions from the UAW, selling off assets like its European operations, and negotiating with its creditors to get them to swap their debt for equity in the ‘New GM’.

It was this last part – the negotiation with creditors – that proved to be the most fraught part of Chrysler’s bankruptcy process. So it seems to be with GM.

Only with that CDS twist.

The point is this: because many of its creditors have insurance against default, through their CDS purchases, GM is finding it very difficult, if not impossible, to get them either to swap debt for equity, or to take a ‘hair cut’ on their debt. They’d be better off if the company defaulted and fell straight into bankruptcy without having a plan agreed beforehand because their CDS insurance would cover them dollar for dollar.

So the hedge funds and other folks who lent to GM see no reason to go along with its plan. They seem to be just fine with default.

And that, as we say, throws a mammoth wrench into the works.

It also explains why creditors have been oddly indifferent in recent years to the performance of the companies in which they invested. They didn’t give a hoot. Instead of being motivated by the risk of their investment and therefore anxious to make sure the company avoided default, they actually welcome it. How perverse is that? Risk takers who are so risk averse that they take none, yet want to be paid for taking the risk they assiduously avoid.

Wonderful.

Come to think of it, this sounds like a great new scam, I mean investment strategy: set up a hedge fund specifically to buy debt in distressed companies, e.g. the US auto maker of your choice, rake in the above average yields that distressed debt inevitably pays, and then watch as it defaults so you can get your money back. Guaranteed. Oh, and that guarantee is based on the full faith and credit of the US taxpayer since the CDS business is dominated by banks that are ‘too big to fail’. As long as the arbitrageurs don’t eliminate the margins in the scam, you’re golden. And they won’t because they also work for the same ‘too big to fail’ banks that sell the CDS.

This doesn’t sound very much like the Schumpeterian vision of the ‘creative destruction’ of entrepreneurial capitalism I was taught, but it is an insight into the games being played by our banks.

Nor does it explain why GM’s shareholders were so compliant for so long as the company’s mangers destroyed shareholder value with a ruthless efficiency they were not able to match on the shop floor. Clearly institutional investors aren’t driven by the textbook version of capitalism either. I am not sure Hayek, Schumpeter, and the others would necessarily include the words ‘supine’ or ‘compliant’ in their descriptions of the virtues of a typical red meat capitalist. But institutional investors are both. And they don’t even have CDS coverage to explain away their indifference.

Meanwhile back at GM headquarters in downtown Detroit [and I hear they want to move to warmer climes as part of the bankruptcy plan] someone is ruing the day that Credit Default Swaps were invented.

Aren’t we all?