many bondholders have bought insurance on the bonds in the form of credit default swaps, which pay off only in the event that GM formally defaults on its debt. The Depository Trust & Clearing Corp., Sender reports, "estimates that CDS holders would receive net payments of $2.4 billion if GM were to default." If they swap the bonds for stock, there's no default, and the insurance policies they've bought on the debt become worthless. So bondholders face a choice: If GM defaults, they will receive guaranteed, fixed cash payments in June. If GM avoids bankruptcy, they will receive a slug of stock that may or may not be worth something.

Is it AIG that will pay off those CDS for GM bondholders? If so, it's pretty ironic that the gov't took over AIG to save the financial system because that would mean if AIG had simply gone bust the GM bondholders would have every reason to take the stock and keep GM solvent.

Steve:

One of the problems with the derivative's market is there is no transparency. No one knows who wrote what or who holds what in what amount or quantity. AIG wrote CDS based upon its name alone with the premiums from the CDS going to the FP portion of the business. A good scam when it was working. The CDS we are talking about are about the default of GM and are not covering bonds persay . . . naked CDS. Buying up bonds would given them coverage. Best move on Obama's part is to drive the naked CDS into bankruptcy. These are the ones creating the issues.

Naked CDS: "A naked CDS is one where the buyer has no risk exposure to the underlying entity; hence naked CDSs do not hedge risk per se, but are mere speculative bets that actually create risk." Wikipedia

Does the "no risk exposure" part of the naked CDS mean that the CDS holders don't actually hold any bonds, or are they just insured multiple times on bonds they do hold?

If they don't actually have any of the bonds, then they have no influence on the course of the process, and have no standing to force the issue into bankruptcy court. If they're bond holders who are insured multiple times over on their bonds, then only some of the CDS contracts can be considered "naked" and at least one would be "legitimate".

Also, it would seem impossible to actively drive someone with no risk exposure into bankruptcy themselves. At worst they could be prevented from recieving a payment, but since they've already paid for the contracts and can't book the cash until it arrives that wouldn't leave them any worse off after GM goes under than they are today. Unless you're proposing the seizure of other assets belonging to those holding naked CDS coverage on GM bonds, in which case that pesky little U.S. Constitution (I thought the left is still claiming to care more about that than the right this week, but I may be out of the loop on that) would get in the way.

bm:

Several things going on here and I will try to explain . . . hopefully.

"The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG." <link> "Investment Banks . . .

"When asked about so-called naked credit default swaps, Geithner responded that it would be 'terribly hard' to separate out the riskiest trades from other transactions.

'My own sense is that banning naked swaps is not necessary and wouldn’t help fundamentally,” Geithner said. “It’s too hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.'” <link> "New Rules of the Game"

Derivatives (CDS) are exempt from normal bankruptcy laws and move to the top of the pile before liquidation. CDS/naked CDS were added to this pile of exemptions with the passage of the 2005 Bankruptcy Law. This is how AIG, Lehman, and Bear were taken apart by holders of CDS. Lehman was attempting to have the court set aside CDS holders.

CDS can hold bonds and do not have to hold bonds (naked). What gets quirky about this is the buyers can do shadow transactions and buy the bonds later while holding a CDS on the company. I believe they do have status in court. another article: <link> "Don't Ban Naked CDS"

I wish some of my more up on the topic friends were around.

The article says:

"Why GM May Go Bankrupt: To some of its investors, it's worth more dead than alive."

Under the proposal, the government would get 50 percent, the UAW health care fund would receive 39 percent, existing stockholders would get a measly 1 percent, and bondholders would get 10 percent.

The bondholders don't find this to be a particularly grand bargain. Why?

Well, for the swap to work out, bondholders must believe that a company that is controlled by a consortium of government and union officials can thrive in a hypercompetitive global marketplace.

In addition, many of the bondholders are empty creditors: That is, they stand to gain more from a bankruptcy filing than from an effort to reduce the company's debt outside of bankruptcy.

----

Your article misunderstands why the bondholders will reject the offer for two reasons:

1) By omitting the comparison between the recovery by bondholders and the union you hide the most important reason for rejection. As the WP editorial says: "GM bondholders, for example, are being pushed to accept a 10 percent equity stake in repayment of their $27 billion in loans to the company. The United Auto Workers, on the other hand, is being offered a 35 percent equity stake in exchange for its claim of roughly $10 billion." <link> Do the math and see the inequality.

2) The FT article says there exists a large number of GM CDS. But are CDS owners also voting bondholders? I don't know what percent of the GM bondholders hold them and neither do you or the FT. However, I don't think it likely that the retail bondholders ( XGM, RGM, BGM, GMS ) are hedged because these are generally individuals with tens of thousands in GM bonds. I don't think it likely that the bondholder's committee would make a counter offer that would keep GM out of bankruptcy if they were motivated by CDSs. With equal evidence, you could say that holders of the CDS are cheering the Auto task force on to offer a unfair deal so that a bankruptcy event occurs. Remember the deadlines are being set by GM under pressure from the auto task force.

Thanks, that helps some.

I would tend to think that anyone who isn't a holder of debt or equity securities issued by a particular corporation would have standing in court proceedings regarding that corp's bankruptcy, which would include the subset of "naked" CDS holders who don't own bonds covered by their swaps.

For those with multiple swaps against a particular debt holding, isn't it possible that part of the reason for getting into that situation would be protection from counterparty risk on some of the swap contracts?