On May 13th Geithner finally put forward a plan to regulate the credit default swap market. Everyone knew it was coming, there was no surprise in the government extending their reach. But what it did not address is the new dynamic created by the CDS industry.
Recently Financial Times has reported that of the 34B USD in GM debt, a large majority of it has been hedged away by the bondholders using CDS and possibly other derivative instruments. Thus, it has been noted, that most bondholders currently feel there is a possibility of higher return collecting on their CDS protection than restructuring and hoping for a turnaround. This is the equivalent of not calling the fire department when your house is on fire because you feel that you can return more on insurance than the value of saving the home. Good math, bad corporate citizenship. There is a lot at stake with many families, corporate partners, and local government entities that rely on this industry to generate commerce. Thus when the government holds debt restructure talks coming later in May to achieve 90% committment from the bondholders, the wrong people will be at the table.
Instead, as a part of the new regulations for CDS, the contracts should also carry the voting privileges of the underlying instrument. Thus if you are a bondholder, and also long CDS to achieve a net short debt position, you should not have the right to vote in any restructuring event regarding the company you will profit from in default. Your debtholder rights should be transferred in percentage allocation to the notional value of your debt position hedged to all of those counterparies that have absorbed the risk of the default of the instrument. This will require a strong regulator body and a more sophisticated clearing system, or just strong legal punitive measures for non-compliance. But providing this transfer of rights is a necessary way to ensure you don't have arsonists buy a seat at the table when you vote whether or not to save a burning house. In this case, the burning house is GM.