Anyone who reads this blog knows that from time to time, I write about happenings in the financial world.  I have touched on mortgage backed securities as well as some of the complexities of AIG and the bonuses they received earlier this year.

I have been following the plight of GM since last summer, when it appeared that GM was headed for trouble.  They were burning through cash, the credit ratings were deteriorating quite rapidly, and they were simply not innovating and coming up with new products to compete in the global automobile market.

And now fast forward to the present.  GM is struggling to stay afloat.  GM has asked their bond holders, who hold some $27 billion in debt, to swamp their debt for a 10 percent equity stake in the company.  Many of these holders are large institutions such as pension funds, mutual funds, and investment banks.  Most of those firms, in an attempt to mitigate their risk purchase a complex insurance contract, known as a credit default swap, or CDS.

Swaps contracts are essentially insurance protection for bondholders in the event of a default by the bond issuer, in this case GM.  So, what does this mean in plain English?  GM may be worth more to these bond holders as a bankrupt firm than if they vote to take the 10% equity stake.

What is even more interesting, is that guess which large insurance company was probably an underwriter of such contracts…..AIG.  This complex relationship of counter parties and the entire swaps market is going to make the GM looming bankruptcy of GM long and protracted.

I am quite certain that not all of the bondholders have CDS protection, but I believe only 10% of the debt holders have to not agree to take the debt to equity swap deal.  If that is the case, then GM will most likely have not other option than to seek Chapter 11 bankruptcy protection.  That means that those bondholders who do hold swaps contracts, will bee seeking a payment from the issuers of those swaps from firms like AIG.

The interesting part of this, from a finance perspective, is that this is a clear example of a legitimate use of a credit default swap instrument.  The bond holders have a real interest in GM, that is holding their debt in the form of a bond.  That is risk that they were looking to mitigate and transfer, in the form of insurance protection or credit default swaps.  Most of this debt was not bought on the basis of speculation and therefore the swaps are, in my opinion, legitimate.

If GM ultimately is not able to convince the bondholders to take the equity deal, I foresee a new era of regulation as it pertains to credit default swaps and the entire derivatives business.  These instruments are incredibly complex, in that they are sold and resold amongst a handful of counterparties with very little transparency.  A GM bankruptcy would being to shed some light on this issue and will most likely be a catalyst for reform.

I imagine we will find out soon as the bondholders have until June 1st to decide what deal they are going to take; the insurance payout from their swaps contracts or a 10% equity stake in a company that has a very turbulent and uncertain future ahead of it.