It seems that every now and then credit derivatives arise as the public whipping boy among financial products. Most recently, the case of Windstream has been publicized as another example of evil credit derivatives in an article, “What Hedge Funds Consider a Win Is a Disaster for Everyone Else,” by William D. Cohan in the May 2, 2019 New York Times. The article includes the following statements:

“… the misuse of financial instruments is creating perverse incentives, rewarding crafty creditors for forcing companies into bankruptcy. Thanks to a lack of rules requiring creditors to be transparent, companies, their employees and their investors may have no way of knowing a creditor’s real intentions until it’s too late.”

“The main, but not the only, culprit is a form of financial insurance called credit default swaps – and the hedge fund wiseguys who wield them like cudgels. Credit default swaps, you may remember from the 2008 financial crisis, allow creditors to insure themselves against the risk that the borrower responsible for debt they own might go into default. Buying insurance means that in the case of default they can still get paid back 100 cents on the dollar.”

“What hedge funds have been doing is buying the debt of troubled companies at a discount for pennies on the dollar, from creditors who are eager to unload it, and then purchasing insurance on the full value of the debt. If the company later defaults on the debt, that clever strategy can pay off big time.”

“So instead of trying to find ways to keep a company out of bankruptcy – say, by restructuring repayments or lowering the interest rate owed or adjusting other terms for a loan covenant to avoid default – hedge fund managers have been pushing the companies that owe them money into bankruptcy. The hedge funds figure they can make more money from the insurance payoff than they can from getting their principal repaid.”

“While that tactic may be perfectly legal, and highly rewarding for the hedge fund, it’s a disaster for everyone else: the company and its employees suddenly faced with bankruptcy, other creditors who haven’t insured their risk and, of course, the insurers who have to make good on the defaulted debt.”

Not a pretty picture … nor a very accurate one!

As a former credit officer at a major bank and a long-time practitioner in the derivatives markets, including (full disclosure) credit derivatives, my first observation is that credit derivatives are not insurance. Insurance involves receiving premia from many policyholders, only a few of which suffer losses, so that the insurance company still makes a profit on the portfolio as a whole. The writer of a credit derivative contract payable upon default of a referenced debt obligation is relying solely on their own credit analysis of the company to determine the credit spread at which it will assume that company’s risk of default. Any such writer is almost certainly a large bank, is in the business of making credit judgements, and enters into such contracts willingly in order to make money. Any competent corporate treasurer or VP Finance would make it his or her business to know if banks are writing credit derivatives on their debt, and at what rates. Furthermore, as outlined below, Windstream itself conducted the transaction that led to its default; credit derivatives/credit default swaps were not at fault.

Companies that borrow an inordinate amount of debt also do so at their own risk and for their own profit-making incentives. Any financial officer of a company knows that borrowing money (debt) instead of issuing stock (equity) puts the company at greater risk of default, but also usually increases the return on equity (ROE) and therefore, all else being equal, drives up the company’s stock price. Higher stock prices mean management’s stock options rise in value, and other equity investors can sell the company at a higher price when they exit. Nobody forced the company to borrow too much money and to enter into a transaction constituting a technical default; credit derivatives/credit default swaps were not at fault.

Creditors don’t lend money to a company just to help the company do better. They lend money to earn interest income and make profits for their own shareholders. Creditors also routinely take actions that the borrower may not like in order to protect repayment of their loan, especially if the borrower is of lower credit quality. Such actions might include obtaining collateral to support the loan, obtaining parent guarantees or clean letters of credit, negotiating restrictive covenants, imposing dividend or capital expenditure restrictions to conserve cash, and, yes, even … purchasing a credit derivative! Windstream apparently conducted various sale/leaseback transactions which the hedge fund creditor felt was contrary to its interests as a lender, e.g., the borrower no longer had the assets which otherwise might have provided a source of repayment for the loan. So, the hedge fund sued Windstream, the judge agreed Windstream was in technical default, and the hedge fund collected under the credit derivatives. Windstream’s borrowing too much money, and conducting transactions that resulted in a technical default gave rise to its bankruptcy; credit derivatives/credit default swaps were not at fault.

If you want to learn more about how credit derivatives/credit default swaps work and how they are used in the capital markets, check out our Credit Derivatives course offerings at