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Naked Credit Default Swaps

posted by Stephen Lubben

Floyd Norris has an interesting column today in the Times, arguing that speculative (i.e., "naked") credit default swaps should be outlawed. As I've long noted, credit default swaps (CDS) do have problematic effects on the bankruptcy system. CDS can encourage creditors to file involuntary petitions that trigger the swaps. CDS also discourages out of court resolution of financial distress, since a bankruptcy filing is more valuable to a creditor with CDS, as many North American CDS contracts will not be triggered by a non-bankruptcy restructuring. And nobody has studied the effects of receiving a CDS payout on post-petition creditor behavior.

But none of these bad effects are the result of an investor who holds CDS without owning the underlying debt -- indeed, these effects only arise from hedged creditors, not holders of naked CDS positions. Such CDS investors have no direct role in the reference entity's bankruptcy case or workout, and only can hope that the CDS market will influence the debtor's fate.

Moreover, I continue to struggle with the attacks on naked CDS, because on some level they are really not that different from pork belly or orange juice futures bought by those who don't indulge in either pork or OJ. Yet we don't see a lot of hand-wringing about the incentives futures create to burn down orange groves.

The difference is that CDS references a specific company, rather than an entire industry. Credit is not a commodity. But the Norris article, nor any other that I'm aware of, does not address why this difference matters.

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