I don't think it's hard for anyone to "get." What's the problem, may be the better question. Lenders lend money, and can insure against the borrowers default. That means they'll lend the money cheaper, since they don't face the possibility of haviong their debt restructured for them in a bankruptcy court. If I lend my neighbor 10 bucks and her agrees to pay me 12 in a week, and I assume the risk that he wont pay it. Maybe I don't want that risk, and prefer to buy default protection for $1.5, because I am happier with 0.5 return on my loan with no risk than I am with possibly a $2 return, possibly no return, possibly some other random return, each with their own unprediactable likelihood. ^if I'm the guy who prefers a certain 0.5 no matter what, then I do that deal. WTF is the problem with that? Maybe I would have demanded 15 in return for my 10 loan if the protection wasn't available, because I have doubts about getting paid back. The vicious loop of credit being the most expensive to those who need it most is obvious. Given that I can buy protection for 1.5 I agree to lending 10 and getting 12 back. Assuming that I don't have charitable reasons to lend to my neighbor, everyone is better off. What is so complicated about that??? If you're saying that lenders should share in the socially beneficial "getting fucked by your borrower" that's fine too, but then no-one better complain about rates being high...
I'm still not sure you fully understand how a bankruptcy works. Let me try again (I think you are arguing your points in good faith and this is just something you aren't familiar with), When a company defaults in a payment, the "automatic" thing that happens is that creditors have a right to liquidate the firm under chapter 7. This is something that equity holders don't want, since it will probably wipe them out. So, they file for chapter 11 bankruptcy protection, which stays the creditor's right to seize the firm's assets. The point of bankruptcy is for the equity holder and bond holders to come to some sort of an arrangement that doesn't involve liquidation so that the company can continue as oppose to being liquidated. So, bankruptcy, which is short for bankruptcy protection, is in the interest of the equity holders. The opposite of bankruptcy is liqudiation, which destroys the equity holder. A bankruptcy has such a broad set of power to muck up everything (including setting aside contracts), that they are referred to as the j-factor in the debt investment community. And you were right - it should be priced into the yield for bonds - and it is. My bond analysts do a whole lot of work to figure out what the bankruptcy outcome and value might be for the bonds that we buy. So, since in bankruptcy a debt holder and an equity holder are effectively both part of the bankruptcy proceeding trying to divide the exact same pie, I'd argue that equity holders holding puts is EXACTLY the same as bond holders holding CDS.
Well, nothing you said refuted what I've been saying about the bankruptcy process first of all. Second, equity holders holding puts is not exactly the same because it will never be more beneficial for the equity holder to allow the equity to go to 0 just to collect some money on the put. For every dollar lost you gain one? Now, equity holders holding CDS shouldn't be allowed either probably. Again, this would give a financial incentive to liquidate a firm that has tangible economic value to society/employees/stakeholders if there was simply some financial restructuring.
Well... that isn't true. Since in a workout, chances are the equity holder needs to give equity to debt holder to compensate them for them losing their claim, the net value that an equity holder gets out of it has to be less than what he went in with. So, say the equity holder has $1 worth of equity, if the company liquidates, he collects $1 for the put, but if it reorganizes and give 50% of the equity to the bondholders as part of the plan, he only gets $0.5; So, he's better off with the put. By the way, just to demonstrate the connection, there's actually an arbitrage style trade you can do with CDS on one end and equity puts on the other; So, my position is, you ban CDS, the same logic require you to ban equity puts as well; otherwise, layoff and worry about regulating incentives instead so that it doesn't pay to take excess risk.
I didn't say he won't be better off with a put if they re-organize. I said he won't be better off holding a put if the firm is liquidated and equity is wiped. If he's holding $1 and it's wiped and given to bond holders. He loses $1 on equity, but gains $1 on the put.
But that's not what happens in a bankruptcy. That's what happens in a liquidation. In a bankruptcy, the bondholder agree to cancel the debt (for example), in exchange for say $0.5 worth of equity. So, in a bankruptcy proceeding, theoretically a fully put-hedged equity holder can now presumable push for the socially unfavorable outcome of liquidation instead of reorganization because he gets more money out of it. This is exactly the thing you fear the CDS-hedged bond holders would do, no? Moreover, you could argue similarly that a CDS hedge bondholder, now made whole because of the CDS payout, is more likely to settle with the equity holder and take stocks, and let the company emerge more quickly from bankruptcy as an on-going concern. The argument allows both cases to happen.
And you can chalk all that lack of regulation for CDS' to none other than Texas Republican Phil Gramm and his "Commodity Futures Modernization Act of 2000".
This is hilarious. Buy the debt, buy an astounding amount of CDS contracts and then push for the company to fail so that you can get paid out. Meanwhile, the entity selling you CDS contracts is collecting fat profits. Sounds fair on the surface until we get into the reality of the matter and the kicker. When the company fails, the taxpayers end up paying it, and against their will, as no private profit driven entity could ever sustain paying out on CDS contacts.
This is why, although I am filled with trepidation at times venturing into areas that may be over my knowledge base, if my understanding of CDSs and their private party nature is correct (i.e. they are private contracts, unregulated and not tracked by any agency, with no transparency), I would have to say it is beyond idiotic for the situation we now find ourselves in, where companies like AIG and Lehman can hold the entire U.S. financial system and taxpayer hostage for trillions of dollars, as a result of deregulation of such powerful instruments being allowed to be transacted and posing such systemic risk to innocent parties. Free markets are great until the market crushes your house in the middle of the night, through no fault of your own.
What is hilarious is your ignorance. How, do tell, does a debt holder push a company into default? The debt holder might refuse to further finance the company, but so what? That's their right; Even in this extreme case (where the debt holder is a bank that refuses to finance a company because its capital market group holds a lot of shorts), it has never occured. There are tons of regulations and laws that make this illegal. No one, not one person, has shown otherwise; There is no structural difference between a CDS and an equity put. I'm not sure why this is hard to understand by a bunch of supposed traders. Should you guys be able to think analytically about financial contracts?