Signage is displayed outside Blackstone Group LP headquarters in New York, U.S. (Photograph: Victor J. Blue/Bloomberg)

The Great Blackstone Swaps Saga Just Became a Whole Lot Crazier

(Bloomberg) -- One of the strangest Wall Street brawls in recent memory keeps getting stranger.

For months now, Blackstone Group LP’s credit unit, GSO, has been trying to profit from a sweetheart debt refinancing it offered an ailing New Jersey homebuilder. The plan calls for Hovnanian Enterprises Inc. to engineer a default that allows GSO to cash in on $333 million of insurance-like derivatives. Unsurprisingly, firms that sold the insurance, including Goldman Sachs Group Inc., protested. One hedge fund even sued, alleging fraud.

Now, in a move that shows just how bizarre this corner of the finance world can get, the homebuilder is asking its creditors to let it refinance yet again -- with new debt so cheap that even blue-chip borrowers would be jealous.

How might a junk-rated company pull off such a feat twice? The answer has little to do with Hovnanian’s creditworthiness and instead presents a window into the sometimes twisted incentives inside the much maligned credit-default swaps market. It also underscores why some market participants are calling for an end to such trades.

Goldman Twist

As GSO moved to wrap up its original trade, rumors swirled across credit markets in recent weeks that Goldman and a hedge fund, Solus Alternative Asset Management, were planning to outfox GSO. The speculation was that they could drive up the price of Hovnanian’s debt, according to market participants who asked not to be identified discussing trading in the privately negotiated swaps. Such a move would have limited GSO’s actual payout, which is directly tied to a CDS settlement auction to be held within the next few months.

GSO seemed to have had that covered. As part of the refinancing, Hovnanian and GSO created enough low-priced bonds to suppress the final settlement price and ensure a juicy payout on its CDS.

Enter Anchorage

But as interest in the Hovnanian CDS trade swelled, speculation emerged that Goldman, Solus and other firms would be able to line up so much demand for Hovnanian’s bonds in the auction that it would cause prices to surge, market participants said. The chatter intensified after another hedge fund, Anchorage Capital, built up a position selling CDS default protection in anticipation that it could profit from the climbing Hovnanian debt prices, the people said.

Representatives for Goldman and Anchorage declined to comment, and a spokeswoman for Solus didn’t immediately comment.

All of this caused the value of Hovnanian’s CDS to plummet in recent weeks, with the upfront price for contracts expiring in December falling from about $3.7 million per $10 million insured to as low as $2.1 million.

That is, until Hovnanian’s move last week.

The homebuilder said Friday that it will swap as much of $840 million of existing securities -- which pay coupons of at least 10 percent and mature within the next six years -- for new bonds paying just 3 percent and maturing in 2047. If enough bondholders swap into the new securities, the market could soon be awash in even lower-priced bonds that would make GSO’s payout even fatter. Sure enough, moments after Hovnanian’s announcement, the value of its CDS shot right back up.

GSO didn’t initiate the latest exchange, a spokesman said, but it hasn’t decided whether or not it will participate. A representative for Hovnanian declined to comment.

Still Fighting

Solus is still fighting GSO’s original refinancing in court after a judge in January declined to grant a temporary order to block the deal. Hovnanian has said that it will only go through with the latest refinancing if at least $150 million of its debt is exchanged for the new notes.
Such an offering could only be designed for one type of investor: those who, like GSO, have bought insurance against a default, analysts at CreditSights Inc. said in an April 6 note. Even Hovnanian dropped a hint in its regulatory filing announcing the exchange.

“There is the potential for an adverse impact to those entities who sold CDS if the new notes were to be deliverable” in a CDS auction, the company said.

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