This article on Credit-default swaps and bankruptcy highlights another instance of collateral damage of CDS (Credit Default Swaps) contracts to the economy. There was another detailed article in FT on the unintentional and negative outcomes of CDS contracts (which I will find and post again here).

It is a commonly held assumption that when a company defaults on its debt, the debt holders try their best to salvage what they can. They may force a management restructuring, a cap on further debt issuance, a cut back on dividends and other such prudent measures. This is one of the many counterbalance measures that force the company management to work harder to turn around the company.

That assumption is no longer valid in the post-CDS world. Many debt holders take huge CDS positions to insure them against default. Ominously the debt holders will actually make more money from these insurance contracts if they allowed the company to fail. So they are voting in the board meetings to let the company default thereby leading to further damage to the economy. What is worse is that the CDS market is completely opaque so no one knows who has vested interests.

Many articles that I read and that blame the credit derivatives markets are actually being too harsh on the industry. The core of the issue here is not proliferation of the contracts themselves. it is actually the opacity and complexity of the contracts. If that could be streamlined the underlying volatility and concentration of risk can be detected much earlier. More on this later.