Sometimes Credit Default Swaps Are Things of Beauty
Why not make CDS buyers and sellers compete with each other to benefit the underlying company?
It would have been more elegant if the company wasn’t already bankrupt.
Photographer: David Paul MorrisA credit default swap is basically a bet on whether a company will default on its debt. When the company defaults, people who sold CDS on that company generally have to pay money to people who bought that CDS. Generally the people who sold the CDS do not want to pay that money, while the people who bought the CDS do want them to pay that money.
If the company is clever enough, this creates an opportunity. It can go to the people who sold CDS and say “if you give us some money, we will be able to avoid default, and you will not have to pay out a larger amount of money on your CDS.” And the people who sold the CDS will offer the company some money. But then it can go to the people who bought CDS and say “if you give us some money to keep our business going despite a default, we will be happy to default on our debt, and you will get paid out a larger amount of money on your CDS.” And the people who bought the CDS will offer the company some money. And then the company can just run an auction and do whatever the side that can pay more wants it to do. “Nice CDS you’ve got there, shame if someone was to [default][not default],” companies can tell each side, and then see who wants it more.