In both of these cases, credit default swaps became an actual bankruptcy catalyst – for the first time ever.

In the lead-up to both bankruptcies, the lenders who had debt outstanding – who would have the right to vote on any reorganization – had hedged their debt through credit default swaps and so stood to benefit from the company’s bankruptcy. That made it very difficult for both companies to get the majorities they needed for debt reorganization, making bankruptcy inevitable.

The CDS holders were in the position of seeing a 1929-vintage stockbroker balanced on a window ledge, and yelling “Jump, jump” – while simultaneously taking bets on the result.

In the AbitibiBowater bankruptcy case, holders of credit default swaps played two key roles:

• They were spectators and potential litigants.
• And they were the generator of lawsuits.

Let’s consider the first point.

When AbitibiBowater missed a bond payment on March 20, there were a lot of CDS derivatives outstanding that were close to maturity. Holders of these securities wanted to have AbitibiBowater immediately declared in default so that they could collect – a delay would allow their credit default swaps to expire.

However, non-payment of bond obligations generally does not become an actual “default” for several days (because the company is given a few days to come up with the money). Moreover, AbitibiBowater obtained a court order allowing the bond payments to be suspended while the company completed its debt restructuring. Thus, the CDS holders (to a value of about $500 million) were out of luck.

Or were they?
An International Swaps and Derivatives Association (ISDA) ruling on March 28 allowed CDS holders (as of March 20) to claim payment through a cash-auction system, as if a default had actually occurred.

The second role that CDS holders played truly was analogous to sadistic spectators placing bets at a suicide. Bowater (which had merged with Abitibi in an over-leveraged deal just two years ago) wanted to exchange its 9% bonds in order to improve its cash flow and to remove the likelihood of bankruptcy. To do this, it needed 97% acceptance from holders of bonds maturing in 2009 and 2010. The company was only able to get a 54% acceptance – largely because many bondholders also held credit default swaps, and so would actually benefit, rather than lose, from a Bowater bankruptcy.

General Growth, a shopping center developer with $27.3 billion in debt (real money even these days) – making it the largest default in U.S. real estate history – demonstrated the darkening cloud that’s hovering over the U.S. commercial real estate market. It also underscored the risks of being involved with credit default swaps.

General Growth’s mortgage debt had been securitized into mortgage-backed bonds, many holders of which had also bought credit default swaps, so debt restructuring proved impossible. Credit default swaps on General Growth’s vaunted Rouse unit were valued by auction on April 15, and were deemed to be worth 71% of par, so investors in them received $710,000 for each $1 million of CDS they held – a nice reward for voting “no” to a corporate restructuring.

Guess what? If busted insurance giant American International Group Inc. (AIG) was the writer of any of the credit default swaps on either AbitibiBowater or General Growth, we as taxpayers have paid the profits of the guys who forced those companies into bankruptcy.

A comforting thought, isn’t it?

The credit-default-swap rap sheet is becoming quite long. In the AIG case, CDS securities allowed an insurance company to write more than $200 billion worth of contracts, booking the premiums as income and reserving nothing against the potential losses, thus bankrupting itself at taxpayer expense.

Credit default swaps then allowed major banks – such as Goldman Sachs Group Inc. (GS) – to collect large sums through their holdings of AIG CDS contracts, while themselves having protection against an AIG bankruptcy, thus double-dipping at the expense of American taxpayers.

These big financial institutions have now facilitated the largest real estate bankruptcy in U.S. history – as well as the bankruptcy of the world’s largest supplier of newsprint – by preventing creditors from agreeing to restructuring plans.

These same perpetrators were an accessory before the fact in the Lehman Brothers Holdings Inc. (LEHMQ) bankruptcy, because they provided the best-leveraged and highest-volume method by which hedge funds could benefit from a Lehman default – the CDS markets had much bigger volume than the stock-options markets, and better leverage and less risk than a direct short sale of Lehman’s stock. By buying credit default swaps and shorting Lehman stock, hedge funds caused a classic “run” on that unfortunate institution that would probably not have occurred otherwise – or even been possible.

In each of these cases, credit default swaps have imposed costs on taxpayers, on the U.S. and Canadian economies, and on society in general. And these costs are outside the terms of their own contracts.

If credit default swaps were just Wall Street gamblers’ playthings – used to “hedge” exposures and provide gaming opportunities for hedge funds – the securities might have some modest net social utility.

However, in the cases we’ve highlighted, the CDS market has proved to be a means of extracting rents from taxpayers and other outsiders. If AIG had been allowed to go bankrupt properly – causing huge losses to banks, investment banks and hedge funds – credit default swaps might well have died a natural death.

The rescue of AIG provided them with artificial life support – thanks to a U.S. taxpayer subsidy of more than $150 billion – a fact that has perpetuated their existence.

In terms of regulation, a moderate step would be to allow the purchase of CDS securities only by those with an “insurable interest” in a particular debt. Further provisions could be written, providing that voting rights on a debt were transferred as credit default swaps were written on that liability. You could even force CDS securities to be weighted 100% in bank risk capital calculations, as if they were direct loans.

However, even a CDS purchase to offload a direct credit risk can equally well be undertaken by a simple sale of the debt, which would at the same time transfer its voting rights in any bankruptcy.

Since hedging and transfer of a debt position is perfectly possible without the existence of credit default swaps, what valid economic purpose do they serve?

I’m one of the biggest free-marketers on the planet, but these things aren’t the free market, they only work because of bank regulation and the “too big to fail” doctrine. When I ran a derivatives desk in the 1980s, we looked at the possibility of credit default swaps – it was an obvious derivatives application – but we decided that they were impossible to hedge and their payout in default was too uncertain for them to be sound financial instruments.

We were right. The market for CDS securities only mushroomed in the late 1990s because – by that stage in the long economic bubble – bankers had stopped worrying about long-term soundness if it meant they could receive larger short-term bonuses.

Let’s ban them. Wall Street will scream about the loss of income, but that loss will be trivial compared to the amounts taxpayers have already paid to bail out Wall Street from its mistakes. The modest economic benefits of credit default swaps are dwarfed by the costs and distortions they impose.

Taxpayers have rights, too.

[Editor's Note: When Slate magazine recently set out to identify the stock-market guru who most correctly predicted the stock-market decline that accompanied the current financial crisis, the respected online publication concluded it was Martin Hutchinson, a veteran international investment banker who is one of Money Morning's top forecasters.

It was no surprise to our readers: After all, Hutchinson warned investors about the evils of credit default swaps six months before the complex derivatives did in insurer American International Group Inc. Then last fall, Hutchinson "called" the market bottom.

Now Hutchinson has developed a strategy for investors to invest their way to "Permanent Wealth" using high-yielding dividend stocks. Indeed, he's currently detailing a strategy that will enable investors to make $4,201 in cash in just 12 days. Just click here to find out about this strategy - or Hutchinson's new service, The Permanent Wealth Investor.]

Ban Credit Default Swaps? These Corporate Bankruptcies Show We Should

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