Bankruptcy
Did you catch the latest twist on the markets?
Normally when a company like Chrysler is about to go bankrupt the bond holders are really eager to avoid the situation. They are willing to cut a deal and accept $.70 on the dollar or something to avoid pushing the company over the edge and making a big mess where they are only going to get $.40 or $.50 on the dollar and only after a year or so of expensive legal waste. Now the catch is, to avoid bankruptcy you need pretty much all of the bond holders to agree.
But what happens when those bond holders are a hedge fund that has credit default swaps on the bonds? If the company goes bankrupt the default provision kicks in and they get back $1 on the dollar. If a deal is cut they get less. So you can have a tiny minority of bondholders push the company over the edge at huge cost to everyone else because they get a bit more.
Even more wacky- What if the hedge fund only has $10M in the bonds, but they have $100M in credit default swaps? Remember, people start buying them as speculation, not just a hedge on their bond investments. So now their little $10M stake can actually be leveraged into a $90M profit while everyone else goes to hell. This is another classic example of how some of these complex instruments broke what used to be thought of as a well functioning market where everyone has appropriately aligned interests (investors in a company want it to do well, all the right cycles are reinforced in the right ways).
Nice.
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