You Lost Your Job Due to a CDSs

Thousands of people have lost their jobs due to Credit Default Swaps (CDSs) and they don’t even know what a CDS is. A CDS is insurance that a borrower will repay a loan to the lender. Here is how the CDS leads to a job loss using as an example a fictitious company that I will call Acme, Inc. that makes pencils.

Business is good so Acme borrows $100 from Jones Investments to buy a machine to make more pencils. Acme agrees to pay the loan off over 12 months. Energy prices then increase so Acme is making less money on each pencil that it sells and is unable to pay off the loan as agreed upon. Due to the liquidity crisis, Acme can not find a bank to refinance the loan which would enable Acme to stretch out the loan repayment over a longer period of time, say 2 years, by which time Acme expects the market for pencils to improve.

Before CDSs, Acme would probably be able to modify the loan payment terms with Jones Investments because if Jones did not modify the payment terms the alternative would be that Jones Investments would end up with a used pencil machine which would be worth say $50 or Acme would be forced into bankruptcy in which case Acme’s assets would be sold off or the loan restructured in which case Jones would get back only part of the money owed to them, say $50.

However, Jones Investments, when they made the $100 loan to Acme, then bought 5 CDSs for $100 each from AIG on the $100 loan to Acme. If Acme can not pay back the loan per the loan terms, AIG will pay Jones $100 on each of the 5 contracts for a total of $500. Consequently, Jones wants Acme to default on the loan and wants to force Jones into bankruptcy. If Jones refinanced the loan for a longer term then Jones might only get $110 back on the $100 loan versus the $500 Jones will get if Acme goes bankrupt.

The way this scenario plays out is that Acme if forced into bankruptcy, all of Acme’s assets (tools, machines, vehicles, etc.) are sold for pennies on the dollar, Acme’s employees are now unemployed and Jones Investments makes a 500% profit.

The above example is not idle speculation. The above scenario is believed to have contributed to the refusal of GM bondholders and, more recently, to the debt holders of Six Flags Amusement Parks to refuse to a restructuring plan because they could make more money from their CDS contracts if the companies went bankrupt.

CDSs are not centrally cleared so it is almost impossible to determine who holds what CDS contracts. There is even the possibility that some lenders have actively worked to force companies into bankruptcy on which they hold CDS contracts by shorting the equity to force the stock prices down of borrowing companies.

There is the argument that the availability of CDSs lowers the borrowing costs for some companies so CDSs are good for the economy. However, since CDSs are not regulated and no reporting is required, it is impossible to know if this is true and almost impossible to determine if CDS holders are manipulating the market to force defaults.