Credit Default Swap Holders Changed Laws So They Get Paid Ahead of Bankruptcy Creditors

You probably know that credit default swap counterparties drive company after company into bankruptcy.

And you probably know that they are getting billions of dollars of taxpayer funded bailouts,

But did you know that – once a company they are betting against goes bankrupt – the CDS counterparties cut in line in front of all of the bankruptcy creditors to get paid?

TPM summarizes the story:

One of the features of the 2005 Bankruptcy bill was to put derivative counter parties at the front of the line ahead of other creditors in bankruptcy proceedings. Actually, from what I can tell, they don’t just go to the head of the line. They got to skip the line entirely.

As the Financial Times noted last fall, “the 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.”

Great. As if CDS weren’t causing enough problems, they often elbow out all other creditors who hold claims against a bankrupt corporation. One question: Does that include taxpayers who are paying for the bailouts?

Note 1: I am for reigning in CDS. But even if you are opposed to regulation, everyone should be against letting powerful groups manipulate laws to game the system.

Note 2: Please don’t direct your fury at those folks people whose day job is to trade CDS, but who don’t have a say in policy or practice (like the financial blogger Tyler). It is the giant financial companies and wealthiest investors — and their lobbyists and political yes-men — who deserve our anger for gaming the system.

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  • So if I understand it CDS holders jump to the front of the bankruptcy line (pari passu with depositors in the case of a bank?) and therefore there is an additional incentive for them, who could well be also an unsecured creditors, to prefer default of the institution. For them, the insurance policy is worth more than any asset, right? Wow! Now I understand why (case of AIG?) it’s better to unwind CDS contracts and pay counterparts. Under these circumstances it’s really better to set up the new good bank or insurer as a completely and legally separate entity and see what CDS holders would do and where they put their claim…

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