Why credit swaps encourage bankruptcy – HTTW – Salon.com
Why credit swaps encourage bankruptcy
As if credit default swaps needed any more bad press! The Financial Times’ Henny Sender reports today that credit default swaps may have left two big-name companies with no other option but to declare bankruptcy this week, instead of concluding out-of-court restructuring deals with their debt holders.Here’s how it works: A lender buys the bonds of a company — let’s say General Growth, the huge mall operator that declared bankruptcy this week. But then, hoping to hedge against the risk that General Growth might default on its bond obligations, the lender purchases a credit default swap protecting against that event from another party, in effect buying insurance against the chance that those bonds will go bust.But the kicker is that owning a credit default swap on General Growth bonds turns out to make the lender less willing to cut a deal that would allow General Growth to avoid bankruptcy, because the lender can get paid in full in the event of that bankruptcy by collecting on the insurance policy. So it’s better for the lender to force the company to its knees rather than come to a less disastrous arrangement.