The problem now? As Salmon points out, bondholders in troubled corporations also hold these CDS insurance policies and some of their insurers are able to pay out. So what's the incentive for these bondholders to negotiate completely with the troubled entity whose bonds they hold if bankruptcy itself could actually lead to a higher payout than offered in pre-bankruptcy negotiations?
Let’s say that I buy $1 million of bonds. In order to protect my downside, I buy $600,000 of credit protection: if the issuer goes bust, I get $600,000, and a healthy 60% recovery value. I don’t want the issuer to go bust — I’d much rather the bonds continued to perform, and to be worth $1 million. But at least I can’t lose more than $400,000 in the event of default.
The issuer then gets into serious difficulties, and the bonds start trading at 25 cents on the dollar: my $1 million of bonds are now worth just $250,000 on the open market. The distressed issuer then seeks to avoid bankruptcy by entering into negotiations with its bondholders. “If we default and are forced into bankruptcy,” they say, “then bondholders will end up collecting no more than 20 cents on the dollar in a liquidation. But if you agree to a restructuring which keeps us out of the bankruptcy court, we can get you a good 45 cents on the dollar in value.”
Normally, bondholders would be well disposed to such an offer. But in this case, I might think twice. If the restructuring doesn’t count as an event of default for the purposes of the CDS contract, then I might end up with just 45 cents on the dollar — $450,000 — if I agree to the company’s plan. If I just let it go bust, on the other hand, I get $600,000.* And so I have an incentive to opt for the more economically-destructive option.
See that? Bondholders with good CDS policies have "an economic incentive to opt for the more economically destructive option." This is definitely something to watch. Oh, a caveat from Salmon - the example actually is worse...
*Update: Hemant, in the comments, points out that I actually get $700,000, not $600,000: I get $600,000 from the hedged portion, and also another $100,000 (25% of $400,000) from the unhedged portion.
I do not agree with Salmon's analysis after his example as to what should and should not happen. But in a response that I normally criticize when it comes from others, my only one is that I don't know enough at this point to offer an alternative.
But when you see mainstream media interviewing regular "Janes and Johns" on the street, just bear in mind how subtle and how very complex this entire economic and Wall St mess really really is.