Fresh from Wall Street's alchemy labs: Credit derivatives tied to General Motors Co. debt. The rub is, no such debt exists.
Banks and hedge funds are trading credit-default swaps, which make payments to holders of General Motors bonds in the event of a default. But GM canceled $40 billion of debt in bankruptcy and has pledged to cut its remaining $4.6 billion bank loan to the bone this year.
The banks argue, I'm sure, that this is a mere technicality, and that the price of these CDS reflect the "credit-worthiness" of the company.
There's a problem with that premise though. In order to default GM would have to have debt upon which to default. And if they were to declare bankruptcy (an act that normally is a trigger on a CDS) in order to collect your "winning" bet you would have to tender something that doesn't exist.
It was bad enough during the "go-go" years when these banks put together complex instrumented constructed in whole or part of these CDS, comprising many times the actual value of the bonds that existed. This resulted in some interesting circumstances when the company went bankrupt - suddenly the bonds were worth many times their actual recovery value, because in order to get paid for your "credit protection" you had to have one. So people would pay up for a worthless piece of paper, simply to be able to collect their winning bet. I would not be at all surprised if a forensic series of audits found that the same bond was used more than once - that is, CDS holder "A" would buy said bond (which he didn't have) of the bankrupt entity for 20 cents on the dollar, tender it to the writer of the CDS, collect, and the writer would then sell the bond for 25 cents to someone else who then used it for their CDS transaction. We'll never know, of course.
But this is a particularly outrageous development in that if a credit event does happen (e.g. bankruptcy) the alleged protection is in fact worthless, since there are no bonds - at any price - to be had.
"Sure, having CDS without debt looks odd, and people may balk because credit derivatives were at the center of the AIG collapse, but that doesn't change the fact that CDS prices are the de facto benchmark used to measure the state of the credit market," said Kevin McPartland, senior analyst at research firm TABB Group.
Selling something that cannot be redeemed in the marketplace because the predicate item does not exist that is necessary to collect on your wager is pretty far out on the scale of "bogus transactions", wouldn't you say?
"I would take it people are pretty confident that GM will issue bonds again at some point in future, but there could be a problem in the auction if there was nothing to deliver," said Matthew Magidson, chairman of the derivatives practice at law firm Lowenstein Sandler.
I would argue that someone who sells a thing they know at the present time cannot be perfected and delivered upon has entered into no contract at all.
Remember, you can't have a contract to jump over the Empire State Building that is enforceable, including a sanction for non-performance, because performance is impossible.
If you enter into and are paid for performance of a contract when you know at the time performance is impossible I contend there is an excellent argument that you have committed fraud.
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