The Financial Times reports that credit default swaps may be undermining companies’ attempts to reorganize in bankruptcy. When a debtor company attempts to reorganize, the success of the reorganization often depends on creditors agreeing to reduce, extend the repayment period of, or otherwise modify the outstanding debt owed to them by the reorganizing debtor. A creditor would be willing to do this because the modified debt would lead to a larger repayment than the amount the creditor would receive in the event of a liquidation of the debtor company.
Thus, corporate reorganizations are made possible because lenders have an interest in keeping their debtors from being liquidated. However, when lenders take out credit-default swaps on debtor companies as insurance on their loans, the lenders stands to receive full or partial payment of the debt from the CDS dealer if the debtor defaults. This payout from CDS increases the total return to the lender in a debtor’s liquidation; thus, lenders holding CDS-backed debt are less willing to accept reduced and/or extended payments from debtors, and corporate reorganizations become more difficult, if not impossible, to structure.
Should the bankruptcy law be modified to somehow fix this severing of a lender’s and debtor’s interests? Could a bankruptcy court revive a CDS-backed lender’s incentive to compromise by modifying CDS contracts or by increasing the benefits of a reorganization? Or could the CDS dealer who inherits the lender’s anti-liquidation interest somehow be brought into the equation?