CDS's and their Twisted Incentives

I love this stuff. I wrote some time ago about how the CDS market was dictating the rates that companies were forced to pay when trying to borrow money. This implied the CDS market knew best which is a dangerous president.

Today Henry Sender of the FT reported about how lenders who covered their loans through the CDS market are actually pushing their own borrowers into default so they can collect the CDS payoff instead of negotiating with the borrower. This is perverse and brings to light again the reality that these "derivative" contracts are insurance and if enough companies with significant debt are forced into bankruptcy, there will be great strains on companies who sold these products and we could see more "bail outs" in the near future if the government is stupid enough to continue throwing money after the idiots who wrote them.

The articles (may require subscription) states in part:

Credit default swaps, the derivatives instruments that have figured prominently in the global financial crisis, are now being blamed for playing a role in two bankruptcy filings this week.

Bankers and lawyers involved in restructuring efforts say they are concerned some lenders to troubled companies, such as newsprint producer AbitibiBowater and mall owner General Growth Properties, stand to benefit from a default because they also hold default swaps, which entitle them to payments in such events.

“We have seen CDS becoming a significant factor” when negotiations on out-of-court restructurings fail, said Alan Kornberg, the partner in charge of the bankruptcy practice at Paul, Weiss, Rifkind, Wharton & Rice, speaking generally. “We used to talk about the practice theoretically but now we see cases where it is hard to get lenders to agree to tender or to compromise and then you find out that these holdouts had significant CDS protection.”

Such exchange offers require the support of a significant number of lenders, 97 per cent in the case of bondholders in this case. But those who withhold support often have powerful incentives to do so, either because they hope to be made whole or because they are seeking to force a filing that would trigger payments under their credit protection agreements, bankers and lawyers say.

So lend with abandon because you can "cover yourself" with some of those profits from writing the loans by buying "protection" from whatever idiot is crazy enough to write a contract on the debt. This reality has much to do with why we are in the mess we are in and how our US spineless government continues to fail to regulate this industry or it's players and instead shoves cash into the accounts of incompetent idiots who wrote the contracts for the benefit of those who purchased the contracts. Now the government owns the banks that benefited from the bailout and the company of the largest number of idiots who wrote them. Is there a conflict here? Are there conflicts everywhere? Can the government "be the market"? Hell no.