Bloodsport on Wall Street: Hedge Funds Make Mayhem for Profit
(Bloomberg Businessweek) -- Conventional investing isn’t a zero-sum game: One investor can buy shares of Apple Inc., and another can buy Microsoft Inc., and both can make money. Even if the two companies brutally compete with each other for market share, both can grow as long the technology business does.
That’s not true with the financial instruments known as credit-default swaps. In this arena, one investor comes out the winner, and the other will be the loser. These derivatives are a way to wager on whether a company will default on its debt. They work like insurance for lenders—except you don’t have to own the company’s debt to buy protection against failure. The trader on one side of the bet collects the insurance payments as long as things go well; the one on the other side can get a big payday if they don’t. Someone’s going to get hurt.
Some hedge funds that invest in credit-default swaps have turned this market into the financial equivalent of Fight Club, weaponizing the fine print in esoteric contracts. They may influence troubled companies to go into default. Or, as in a recent case involving bankrupt Sears Holdings Corp., they might try to engineer the size of the payout from CDS contracts. “The participants in this CDS market are all incredibly sophisticated, with wonderful lawyers,” says Henry Hu, a law professor at the University of Texas at Austin who studies swaps. “They’re endlessly creative.” Such deals are still a small portion of the $10 trillion CDS market. But they’ve gotten so wild that the main trade group for the derivatives industry, which is hardly a bunch of shrinking violets, has proposed new rules to prevent what some consider manufactured defaults.
Take the case that got Wall Street to snap to attention, involving homebuilder Hovnanian Enterprises Inc. In 2017 traders at GSO Capital Partners, the credit arm of private equity titan Blackstone Group LP, offered Hovnanian a low rate on new debt. But there was a catch: Hovnanian had to agree to skip a payment on a small portion of its previous debt. That would trigger a payout on $333 million of CDS insurance that GSO had purchased. One of the funds on the hook for those payouts sued GSO and Hovnanian, claiming manipulation. At the time, Blackstone said the suit was without merit, and Hovnanian said it had acted properly. The dispute was ultimately settled last year; the homebuilder made the missed payment and kept the financing.
Corporate borrowers themselves now have a chance to play dueling hedge funds off one another. Last year newspaper publisher McClatchy Co. struck a deal with hedge fund Chatham Asset Management. Chatham agreed to extend loans to McClatchy, which it could use to pay down bonds. Chatham had been selling CDS contracts insuring McClatchy’s debt. With the bonds paid off and the loans tied to a different unit of the company, Chatham would effectively never have to pay for a default. But then another group of hedge funds offered McClatchy a new refinancing deal that would keep some bonds around and thus retain the value of their CDS trades. McClatchy took it and tweaked its loan agreement with Chatham.
If this sparks a feeling of déjà vu, it should. It was about a decade ago when CDS first made headlines. CDS contracts on mortgage-backed securities enabled rampant speculation on U.S. homeowners and saddled the global financial system with a tangled mess of losing bets. The U.S. government ultimately had to rescue one of the CDS market’s biggest players, insurer American International Group Inc. The fallout led to regulations intended to make the market safer, such as trading derivatives through clearinghouses that can absorb losses when a dealer fails. But even the savviest practitioners didn’t foresee the strange place the market would go next.
That is until 2013, when a GSO trader in London named Akshay Shah dreamed up what seemed like a no-lose CDS trade on a Spanish gaming company called Codere SA. GSO agreed to keep the company afloat with a new loan on the condition that Codere skip an interest payment long enough to trigger a payout on its swaps.
That deal seems simple compared with what’s happening now. When the CDS traders started circling the bankrupt estate of department-store chain Sears, it took a while for the company to even figure out what was going on. After the October Chapter 11 filing, Sears set up a hotline to answer questions. Resellers would call looking to buy up its stock of Kenmore refrigerators. Real estate agents would ask about listings on liquidated stores. Then came some curious inquiries from a bunch of Wall Street types, according to a person familiar with the matter who asked not to be named because the details were private. They wanted to buy an obscure set of notes that were owed by one part of Sears to other parts of the company.
Such unsecured debt would normally be worthless in a bankruptcy. Then advisers for Sears figured out the game. The value wasn’t in the notes themselves, but in the way they could be used during the process of settling the value of CDS contracts on Sears. By digging up more bad Sears debt and buying it on the cheap, traders who bought CDS could in effect show that they were owed a bigger insurance payout. Then another hedge fund, which had sold the CDS protection, snagged the notes from Sears for $82.5 million and was able to keep them from being used by the other traders.
Some in the industry worry that aggressive traders will undermine confidence in the market for swaps. “I don’t know how long the CDS market can survive if it is untethered by the underlying credit risk,” says Robert Pickel, who until 2014 was chief executive officer at the International Swaps and Derivatives Association, the trade group that in March proposed new default guidelines. Pickel advised the fund that sued GSO.
Hedge funds do bring something to the table: They may give companies attractive financing that can help with a CDS trade. Conversely, the CDS market can be a way for banks and investors to hedge their credit exposure and, ultimately, give companies greater access to credit. But who’ll want to provide insurance against a default if some hedge fund can orchestrate one and take you to the cleaners? “In recent cases of defaults causing further disruption to CDS markets, this has flowed into funding markets,” says John Feeney, a former board member of ISDA and the founder of Martialis Consulting. “If you are relying on speculators to provide liquidity rather than regular bank funding, the next company may find it a little bit harder to find regular financing.”
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