Swap Story

My post on financial regulation generated a lot of interesting discussion. In comments, the Epicurean Dealmaker suggested that ATMs and online banking were some mighty fine innovations, and I'm inclined to agree. James Kwak makes a similar point, attempting a classification of innovation into those that make our lives easier (ATMs, cards, online banking, and so on) which are almost always a good thing, and those that extend the availability of credit, which are sometimes good but sometimes bad. I think an interesting question is to what extent deregulation is responsible for the first category of innovations. And if it is, is it the case that we must accept a wave of new and potentially wacky financial products as part of the bargain?

Of course, then you get into gray areas. Are independent mortgage brokers or mutual funds more like the first category of innovation or the second? And are they unequivocally good?

At any rate, the discussion was bound to turn to CDS at some point, and indeed it did. Jomiku defends them, and I've been conditioned by Felix's writing on this score to be sympathetic to his points. So when I saw this post by Megan McArdle, arguing that credit default swaps were making creditors too comfortable with the idea of bankruptcy, I wondered how Felix would respond. As it happens, he kind of agrees.

Now there's one big problem with this story: any restructuring as drastic as the one I described would count as an event of default -- so owners of credit protection would get paid out either way.

But the fact is that whenever bondholders have bought credit protection, someone else -- the protection seller -- is in the position of caring deeply whether or not a restructuring goes through. But at the same time, that person can only cheer from the sidelines, and has no actual role in the bondholder negotiations, since they're not a bondholder. Meanwhile, the bondholder doesn't care nearly as much about the outcome of the negotiations as the issuer would like, since a lot of his exposure is hedged either way.

All of which leads Megan to propose that "swap contracts should allow the issuers to get involved in these negotiations, the way insurance companies sit at the table during lawsuits". This is a bad idea, since there's no limit to the amount of credit protection which can be written on any given issuer. A company thinks its dealing with a known quantity of bondholders, and then suddenly sits down at the restructuring-negotiation table to find ten times as many protection sellers? No one wants that...

The real solution here is to minimize the economic costs of bankruptcy. If the outcome of bankruptcy proceedings is that creditors end up with just as much value as they would have gotten from a restructuring, then there's really no problem either way. When it's done well, bankruptcy is little more than a change of ownership: shareholders get wiped out or diluted, and the old creditors become the new owners. The company itself doesn't need to change much at all.

I guess that's right, but it's not particularly satisfying. People have made a lot of compelling arguments against the growth of CDS, and I've been impressed with the way Felix has been able to mount compelling reponses. But at some point, one begins to wonder whether there are net benefits to the product. Having read Felix extensively, I'm open to the idea that with the introduction of some rules to the market default swaps can be made an unequivocally valuable innovation. But of course, we're then talking regulation, which was the initial issue. One might argue that products must be allowed to first roam free in the wild and blow up so that we can know just how they need to be regulated. Maybe. I'm increasingly inclined to think precautionary regulatory constraints on new products should be the default position.