The Institutional Risk Analyst folks say Citigroup is is insolvent and needs to be either restructured or liquidated. They believe restructuring is possible by three steps:

• Forced management change
• Agreement from bondholders to convert Citgroup's debt into common equity
• A 'prepacked' Chapter 11 filing under the FDIC's open bank assistance

I agree with the diagnosis. Citigroup is insolvent. But I believe that the restructuring is impossible as many Citigroup bondholders have no incentive to take a loss by agreeing to a debt for equity swap but instead have a huge incentive to let Citigroup fail.

The reason are Credit Default Swaps.

One can distinguish two types of Credit Default Swaps buyers:

• A. The CDS buyer that buys insurance against the default of an asset s/he really owns.
• B. The CDS buyer that buys insurance against the default of an asset s/he does not own.

On a first view type A looks like a homeowner who pays for fire insurance on her home while insurance buyers of type B are firebugs who establish insurance on some other person's house to cash-in after  they burn it down.

It is obvious that the second kind of insurance buyer is a serious danger to the public and to the solvency of the insurance seller. Indeed no sane insurer, that is others than AIG Financial Services, will sell fire insurance on a home to someone else than the home owner.

As I call for ALL credit default swaps to be declared null and void I should explain why the first type of CDS buyer is also a systemic danger.

A person gives $1 million credit to Citigroup and receives a bond from it, a written declaration by Citigroup to pay back the $1 million plus a certain interest in a fixed number of payments distributed over time. The person also buys insurance for the full value of the bond. If Citigroup goes bankrupt the insurance will pay out for the full loss to the bondholder. 

But Citigroup is a big company and before such companies go bankrupt and out of business they try to restructure. They will call in all the bondholders and ask those to forgive some of the debt or exchange their bonds for shares. They will also ask their workers to work for less. Such restructuring is usually good for the economy as a whole. Not all company workers get fired and the general economic disruption that occurs with any large bankruptcy will be less painful.

But here is the rub. The bondholder that has insured the Citigroup bond has no incentive to agree to any reduction in what Citigroup owns her. If Citigroup goes bankrupt the bondholder will not bear any loss. Then why should the bondholder agree to take a loss in a restructuring procedure?

Indeed the analogy of this type of CDS buyer to a homeowner that insured his home is not completely  correct. A home fire insurance will not pay out 100% of the rebuilding costs of a home that had already decayed. It might pay the time-value of that house or the repair costs, but the payout for a burned down 50 year old house will usually not be enough for to pay for a brand new one of the same size and quality. This makes sure that the homeowner has no financial interest to burn the house down and gives an incentive to stop a small fire before it burns down the whole house.

But the CDS buyer of the first type will be made whole to 100%. The incentive here is not to stop the small fire but to make sure that the fire actually burns down as much of the house as is possible.

As the Financial Times reports (alt link) that is exactly what happened twice last week:

Credit default swaps, the derivatives instruments that have figured prominently in the global financial crisis, are now being blamed for playing a role in two bankruptcy filings this week.

Bankers and lawyers involved in restructuring efforts say they are concerned some lenders to troubled companies, such as newsprint producer AbitibiBowater and mall owner General Growth Properties, stand to benefit from a default because they also hold default swaps, which entitle them to payments in such events.

The same will occur with General Motors which is now trying to restructure:

The Obama administration has directed General Motors Corp (GM.N) to prepare a new restructuring plan that would pay off bondholders and the automaker's major union in stock in exchange for $48 billion in debt, people briefed on the plan said on Friday.

The GM bondholders who have in total $38 billion credit insurance will certainly not agree to a voluntary shares for debt-reduction swap. Outside of bankruptcy procedures there is little anyone can do to make them accept such. Inside a bankruptcy the insurance makes the whole. GM and Citigroup will thereby have to go into bankruptcies with all the nasty things that will be involved. Likely more jobs will be lost than necessary and more damage done to the economy as a whole while the bondholders who bought insurance will be perfectly well.

It is weird that the Obama administration and even the smart IRA folks have not grasped the problem that CDS' have created. These insurances by their very existence give an incentive to 'liquidationists'. They are institutionalized Andrew Mellon's that prefer total destruction over restructuring.

There is a way out of this: Declare all Credit Default Swaps null and void.

There is no real economic justification for these instruments. They only skew risk. If A gives a loan to B the payed interest is the gratification for taking the risk that B might default. A will demand higher interest from C if C is a higher default risk. That is the way it should be and it has worked well for thousands of years. If CDS' are allowed A will insure itself and no longer carry a risk at all. Any decay in B's financial state will give A an immediate interest to see B's total fall. This is a systemic danger that the public has a clear interest to avoid.

So lets get rid of these papers once and for all.