The "empty creditor": Destroying companies, on purpose, for profit

[KamaAina]

This is unfettered capitalism at its finest, folks. Adam Smith would be proud. :sarcasm:

http://www.slate.com/id/2216604

One key economic assumption is that people act to preserve their economic interests. Those who have lent money to troubled companies, for example, generally prefer the company remain solvent; otherwise, they can't get paid back. Similarly, lenders to troubled firms frequently favor swift, out-of-court restructuring deals, in which they swap debt for stock, instead of pushing companies into Chapter 11 bankruptcy. That's because companies in Chapter 11 can languish there for years and waste scarce company assets on huge fees to lawyers, consultants, and accountants.
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But if a lender or creditor believes it can profit more from a complete failure—i.e., if it has an insurance policy that pays off only in the event of utter devastation—that creditor might be more inclined to push a company toward bankruptcy. And thanks to the financial innovations of recent years—the rampant use of hedging and credit-default swaps, the ability of investors to purchase insurance on debt—that's exactly what seems to be happening. Creditors are acting to protect their economic self-interest by encouraging companies to destroy themselves.

Henry Hu, a professor at the University of Texas law school, been exploring ways in which new players and new financial technologies are warping the traditional behaviors of creditors and owners. He has coined the term empty creditor to describe situations in which people to whom money is owed don't act as if they want to preserve the company that owes them money. For Hu, Exhibit A was the case of Goldman Sachs and the troubled insurer AIG. Goldman, it was reported this spring, was one of the AIG counterparties to whom government money was funneled last fall. AIG posted $2.5 billion in collateral to Goldman under credit-default-swap obligations and made payments of more than $10 billion to the firm to settle credit-default and securities-lending obligations. Hu notes that forcing a troubled company like AIG to pony up billions of dollars in cash as collateral would have been a contributing factor to further erosion of AIG's financial situation, which, in turn, would have rendered many of the financial arrangements Goldman had entered with AIG worthless. But Goldman didn't care that it would wipe out its AIG arrangements, because it had already hedged its exposure to AIG—through contracts, credit-default swaps, or other derivatives. In the words of Goldman's CFO, the firm was "fully protected and didn't have to take a loss." In other words, although Goldman was a significant creditor to AIG, it appeared to have nothing to lose from AIG's demise and potential failure to make good on debt, which is why it was happy to force AIG to disgorge billions of dollars in collateral.

:grr: :banghead: :argh:

[bluesbassman]

1. That is exactly why credit defaualt swaps were never regulated.

Biggest game of Three-card Monte the world has ever seen.:grr:

In testimony last week before the Senate Banking Committee, SEC Chairman Cox pointed out the enormous regulatory black hole in which credit default swaps have come of age since pretty much the dawn of the 21st century. He pointed out that the SEC’s Enforcement Division was focused on using its antifraud authority in this area, and noted that credit default swaps provided a way for market participants to “naked short” the debt of companies without restriction. Cox asked that Congress “provide in the statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets,” but he didn’t say who should have such authority. Interestingly enough, I don’t recall any similar discussion of the lack of authority to regulate credit default swaps and other derivatives up until this point, while the excesses in the market - and the lack of transparency - have been known for some time.

snip

One interesting thing pointed out by the statements of Chairman Cox and Governor Paterson is that no one seems to know for sure how big the market is for credit default swaps. Chairman Cox cited in his testimony “the $58 trillion notional market,” while Governor Paterson referred to the “$62 trillion market.” Any estimates such as these are pretty much educated guesses, since there really isn’t any transparency into the scope of the credit derivatives market. Also, these types of notional amount estimates are often cited to state the size of derivatives markets, but really those amounts overstate the actual exposure that these derivatives present, since the notional amount is really just the basis on which payments are calculated - but not how much any counterparty owes on the actual derivative contract. Something closer to $2 trillion in fair value is perhaps a better estimate of the size of the credit default swap market, at least up until the events of the last few months.

Congress did not yet heed the calls for more federal authority over credit default swaps, as no provisions have been included in the two versions of the bailout bill that would vest regulatory authority over credit derivatives with the SEC or any other agency; however, this may be an issue that Congress will turn to quickly once the latest fire drill has died down.

more...
http://www.thecorporatecounsel.net/blog/archive/001925.html

[Lance_Boyle]

2. This is exactly what's happening to Six Flags at the moment.

One creditor is refusing to even sit at the table to discuss a debt-for-stock exchange. It is believed that the creditor is Fidelity, and that it holds just such a CDS against Six Flags.

[KamaAina]

3. That was the next paragraph!

I could have fit that in under the four-paragraph rule, but held off because the whole article is only five.

Empty creditors seem to be appearing elsewhere. Take the case of Six Flags, the amusement park operator that is strugging with a huge debt load. Six Flags' management is furiously trying to avoid a Chapter 11 filing. Last week, the company announced an offer to swap about $600 million in debt for about 60 percent of the company's stock. Should bondholders not take up the offer and insist on receiving interest payments, Six Flags said it might have to file for Chapter 11. But as the Washington Post noted in this good article on Six Flags' difficulties, not all bondholders are going along. "Six Flags executives have not publicly identified the holdout, but people with knowledge of the negotiations say that a Fidelity Investments fund owning more than $100 million in bonds due in 2010 has yet to come to the bargaining table." It's unclear why Fidelity isn't coming to the table. It could be because they believe the company might be able to make the interest payments. Or it could be because Fidelity, in this instance, is an empty creditor. The Post notes that one possible explanation for Fidelity's behavior is that "the bondholder has a credit-default swap—essentially an insurance policy—that would pay it a higher sum than an out-of-court agreement." Since credit-default swaps are triggered by formal bankruptcy filings—and not necessarily by out-of-court restructuring deals—bondholders who purchased insurance may feel they have more to gain from a traumatic filing than from an out-of-court settlement. The Financial Times reported last week (subscription required) that the logic of empty creditors may similarly have been a reason why General Growth Properties and paper company Abitibi-Bowater both ended up filing (here and here) for Chapter 11 on April 16.

[Lance_Boyle]

4. heh - I thought this article sounded familiar

I must have read it in SIX (now SIXF) news. I, for one, do not welcome being wiped out by my new CDS-holding Fidelity bastard overlords!