Another Weird Deal Upsets CDS Traders

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(Bloomberg) -- Orphan CDS.

Man, what a great time it is to be alive, if you like counterintuitive credit-default-swap structuring. Here’s the latest, from Bloomberg’s Sridhar Natarajan:

In the McClatchy trade, New Jersey-based Chatham struck a deal with the newspaper publisher -- founded in California on the heels of the Gold Rush -- to refinance most of its $710 million of debt with two new loans. The loans will allow the company to trim about $50 million off its most expensive bond and give it a few more years to repay the bulk of its debt. The news did little to boost McClatchy’s $72 million market cap. But because of a condition in the deal with Chatham that would move McClatchy’s borrowings into a new wholly owned subsidiary, the impact was seismic for holders of the derivatives.

In a matter of hours, the refinancing wiped out 70 percent of the market value of a five-year CDS on McClatchy, data compiled by Bloomberg and price provider CMA show.

That was bad news for the hedge funds, banks and other investors that had bought insurance against a McClatchy default. Because the new debt would be shifted away from the parent and into the new unit, it’s fueling speculation that the Chatham deal will create what’s commonly known in the CDS world as an orphaned contract. In other words, anyone who bought insurance on a McClatchy default would effectively be paying insurance on an entity with no significant debt.

But for Chatham, the deal could bring a potential windfall. Leading up to the deal, Chatham had been selling swaps insuring against a default by McClatchy. So if the transaction were to be completed, it would be getting paid CDS premiums to guarantee against a default that could never technically happen.

Super! The trade is pretty simple. (Here is McClatchy’s description of it, which runs to one page.) McClatchy Co., a newspaper publisher, has some bonds outstanding. Two series are pretty much all ($356 million out of a combined $365 million) owned by Chatham Asset Management, a hedge fund. McClatchy is going to pay all of those bonds off, and some other company—an unnamed subsidiary of McClatchy, call it McClever—will borrow the money from Chatham to fund those repayments. Another series (about $345 million worth of 9 percent secured notes) is not owned by Chatham, but McClatchy is going to try to refinance it too in a similar fashion: McClever will offer new first-lien notes (presumably to the holders of the existing McClatchy secured notes) and give the proceeds—along with about $50 million more borrowed from Chatham—to McClatchy to pay off its secured notes. The total result is that all or almost all of McClatchy’s debt will be wiped out and replaced by new debt at McClever with a longer maturity and perhaps—depending on the terms of the new first-lien notes—a lower interest cost. 

That is good for McClatchy (longer maturities, lower interest cost). But it’s really good for Chatham, which has sold CDS protection on McClatchy. Not only will McClatchy get some breathing room on its debt, making a default less likely: If this trade works, a default will be impossible, because McClatchy won’t have any debt. McClever will have debt, sure, but it won’t technically be debt of McClatchy Co., so if it defaults on that debt then CDS on McClatchy won’t trigger. And so Chatham’s CDS—which it sold at high prices reflecting McClatchy’s low-junk Caa1/CCC+ credit ratings—will turn out to be free money. (Except for, you know, the large long-term loan that Chatham is making to McClever.)

People are mad:

“CDS is being manipulated to the point that it potentially invalidates the product,” says Mike Terwilliger, a money manager at Resource America Inc. “Fundamentally, markets rely upon valid prices. How can I use a product if I need to worry that counterparties are trying to vandalize capital structures to contort CDS contracts?”

And:

“The whole market is losing credibility when you have events like this where you try to trigger the CDS or create orphaning situations,” XAIA’s Felsenheimer said.

Look, I am extremely here for defending spivvy CDS transactions, but this one isn’t even that spivvy! Imagine this transaction:

  1. Chatham sells CDS on McClatchy, betting that it will be able to pay off its bonds.
  2. Chatham buys McClatchy bonds, betting that they will be paid off.
  3. Chatham just pays off McClatchy’s bonds for it.
  4. The only condition to this act of extreme generosity is that McClatchy has to agree not to issue any new bonds (out of the parent company that count for CDS purposes).
  5. McClatchy CDS is now guaranteed not to pay out.
  6. Chatham loses all of its money on the bonds, but makes money by collecting CDS premium with no (future) risk.

This would be a dumb transaction—it would cost Chatham more to forgive the bonds than it would make on the CDS—but I think it would be okay? Maybe it’s a little manipulative, sure; doing something uneconomical in one market in order to get paid off on a related derivative is a classic core case of market manipulation. But I am still of the belief that doing a trade directly with an issuer doesn’t really feel like “market” manipulation; you are not goosing markets to move them away from reflecting reality, but changing reality instead. Maybe it’s insider trading, if Chatham coordinated with McClatchy before selling the CDS, but in this trade there’d be no need for that coordination because Chatham is offering so much (free debt forgiveness!) for so little. And maybe CDS buyers would be a bit aggrieved, but they’d really have no leg to stand on: They bet that the company wouldn’t be able to pay off its debt, and it paid off its debt, so what is the problem?

The actual McClatchy transaction is the same as the fake one I laid out, with the single additional step that instead of paying off McClatchy’s bonds gratuitously, Chatham is actually lending it the money to pay off those bonds, and doing the lending to a new subsidiary that doesn’t count as the same issuer for CDS purposes. I mean! It is different! But once you have accepted my gratuitous-repayment version of the trade, I don’t see why some additional lending to a brand-new subsidiary should bother you that much. I mean, I see it. But it doesn’t bother me.

The thing is, if you bet against McClatchy’s credit by buying CDS on it, you were betting not only that it would have problems with cash flow or whatever, but also that no white knight would come along to keep it afloat until after your CDS expired. A realistic credit analysis asks not only about the company’s own paying capacity but also about its external sources of financing. If you buy five-year CDS on a company, you are betting that it will default on its debt within five years. If the next day a deep-pocketed shareholder (Chatham owns 19.8 percent of McClatchy) refinances all of the company’s debt into a seven-year zero-coupon bond—or a seven-year PIK-toggle bond, or whatever, some form of debt that it cannot default on during the life of the CDS—then you have lost your bet. But you weren’t cheated out of your bet or anything. You just bet that the credit would implode, and then it didn’t. 

This is distinct from the Hovnanian trade, which we have discussed extensively, where CDS sellers bet that the credit wouldn’t implode, and it didn’t—Hovnanian is fine—but there will be a massive CDS payout anyway. That is counterintuitive: You bet on the credit, and your bet was right, but you have to pay out a ton of money. This trade is perfectly reasonable: You bet that McClatchy wouldn’t be able to pay its debts, and it did, so you lost. 

Still I recognize that other people disagree. The use of a new subsidiary seems unsporting; you’re supposed to refinance old McClatchy debt into new McClatchy debt, so that holders of McClatchy CDS will get another chance to see it default. And obviously my enjoyment of this trade—of all the good CDS trades recently, of Hovnanian and Codere and RadioShack—is bittersweet, and is tempered by my knowledge that if there are too many CDS trades that are this surprising and delightful, then they will undermine the boring confidence in the CDS market that allows that market to function. want surprise and delight from my CDS transactions, but my interest in the CDS market is essentially literary; if you have money on the line, you probably want predictability. If every CDS transaction brought this much joy, then they’d soon put a stop to the joy altogether. 

“We’re in the money, the sky is sunny, let’s lend it, spend it, send it rolling along.”

Elsewhere in joyful business news, this video clip of Mike Coupe, the chief executive officer of J Sainsbury Plc, singing “We’re in the Money” on a hot mic while waiting for a television interview about Sainsbury’s acquisition of Asda, is among the purest and most beautiful things I have ever seen. Just go watch it. The performance is amazing, but the greatest magic of the clip is that it gives you a tiny glimpse of an enchanted world where this stuff happens.  “I assume this is what all CEOs do all the time when they think they're not being observed,” I tweeted, and what if it was? What if Mark Zuckerberg walks around the house quietly rapping “C.R.E.A.M.” to himself? What if Elon Musk is so overcome with glee about how rich he is that he literally dances a jig between sending his tweets? What if that famous Jamie Dimon weird-indoor-tennis Christmas card is an accurate depiction of his daily life? What if the lived experience of being a wealthy successful executive consists mostly of singing show tunes about how rich you are? Isn’t that a world you want to live in? Don’t you want to believe that enough money might give you access to that sort of pure innocent delight? I have been singing “We’re in the Money” to myself since I saw this clip, and it keeps making me happy.

Guns, etc.

Should banks make public policy on non-financial issues like gun control and pollution? Here is Bloomberg’s Laura Keller:

Such pressures are mounting: Across the country, activists are exerting unprecedented pressure on banks to wield power normally afforded to lawmakers. Groups, sometimes allied with shareholders, are demanding that the largest lenders use their financing clout to force action on guns, fossil fuels, equal pay for women, helping low-income families and climate change.

Some organizations say they’re targeting the financial industry because they can’t get traction with the Trump administration or the Republican-controlled Congress. 

You can imagine some sort of bottom-line-focused business justification for this sort of thing (it might win favor with certain clients, or help with employee recruitment and morale, etc.), but I don’t know why you’d want to. A corporation is a system that brings together a bunch of people—executives, workers, shareholders, etc.—with a set of governance rules for how those people can collectively make decisions. Many of those decisions are explicitly about how the corporation can make more money for some or all of those people, but many aren’t. Someone has to figure out what kinds of donuts to order for the weekly staff meeting. And if the people in the system—weighting their desires and interests under the governance rules that the corporation uses to make decisions—think that guns are bad or fossil fuels are dangerous or whatever, then they can make decisions that correspond with those beliefs. Bottom-line concerns might influence some of the people involved in these decisions—they might be part of how some of them talk to others—but there’s no reason to assume that they’re the only factor.

The concern, when any giant powerful public corporation does this sort of stuff, is that it is too powerful, that it is making decisions that should be left to national representative democracy. As Senator Mike Crapo put it:

“We should all be concerned if banks like yours seek to replace legislators and policymakers and attempt to manage social policy by limiting access to credit,” the Idaho Republican wrote in a letter to Citigroup CEO Mike Corbat. Banks “should not deny financial services to customers they disfavor.”

Your sympathy with that view might depend on your level of confidence that legislators and policymakers will do a good job of managing social policy. What if the aggregation and weighting of desires through the corporate mechanism just works better than the aggregation and weighting of desires through traditional politics? As politics around the world shift into a nativism-versus-cosmopolitanism confrontation, people who previously trusted legislators more than banks may change their minds. (And vice versa, too.) Big banks have a tendency to cosmopolitanism: They have open borders, they rely on the free flow of trade, and they tend to be run by well-educated urban elites hired based on education but without regard to nationality. It’s not surprising that their politics sometimes turn out to be different from those of national elected politicians.

Meanwhile:

Banks and credit-card companies are discussing ways to identify purchases of guns in their payment systems, a move that could be a prelude to restricting such transactions, according to people familiar with the talks.

Bacoin, etc.

I guess, why not:

Oscar Mayer, the hot dog maker, has launched a cryptocurrency called bacoin, the company announced on Monday. The coin is redeemable for packs of bacon—if you win coins in the first place. You cannot buy them.

It’s “the first ever cryptocurrency backed by the gold standard of Oscar Mayer bacon,” the company touts in a press release. Oscar Mayer also warns that, “similar to other cryptocurrencies, the value of bacoin can be volatile.”

“Of course, the coin launch is just a jokey promotional gag,” notes Yahoo Finance, as though that would distinguish it from other initial coin offerings. Somehow the stock of Kraft Heinz Co., which owns Oscar Mayer, did not double on the announcement.

Elsewhere here’s a story about how Russian spies plan to control the blockchain. Don’t ask what blockchain, I mean, just the blockchain. “Look, the internet belongs to the Americans — but blockchain will belong to us,” said an F.S.B. intelligence agent at an International Standards Organization conference on setting blockchain standards. One blockchain lawyer “said she was worried that countries that devote more resources to the process could successfully push their preferred cryptographic algorithms to be the standards, potentially creating so-called back doors that could be used in the future to spy on blockchain activity.” A thing that you sometimes hear about cryptocurrencies is that they eliminate the need to trust a central intermediary: All the rules of governance are embedded in code, and the code is open-source, and you can audit the code yourself and decide which systems to trust. This strikes me as a somewhat unrealistic view of how normal people use computer systems, but in any case, when you’re reviewing the code, be sure to watch out for back doors built by Russian spies!

Oh and here’s “SoFi's Former CEO Harnesses the Blockchain for Home Loan Startup”:

At SoFi, Cagney targeted so-called HENRYs -- high earners, not rich yet. With Figure, he’s chasing a demo that he’s calling CLAREs -- cash light and rich in equity, the people say. 

How’s the WhatsApp guy doing?

A million dollars isn’t cool, you know what is cool, turning down a billion dollars just because you’re already super-rich, and don’t want to work at Facebook Inc. anymore, and want to spend more time with your air-cooled Porsches:

Jan Koum’s exit from Facebook Inc. could prove costly. A speedy departure may prevent him from collecting as much as $1 billion in stock awards. …

Koum’s decision may be made easier thanks to the $10.4 billion fortune he’s already accrued, according to the Bloomberg Billionaires Index. He’s already sold $8 billion worth of Facebook stock since 2015, according to data compiled by Bloomberg.

"It is time for me to move on," Koum said in the post. "I’m taking some time off to do things I enjoy outside of technology, such as collecting rare air-cooled Porsches, working on my cars and playing ultimate Frisbee.”

Relatable! I hope he hummed “We’re in the Money” on his way to hand in his resignation letter.

Things happen.

Morgan Stanley Plans to Boost Junior Banker Pay as Much as 25%. The math behind the fight at Xerox. U.S. Jury Convicts Former Autonomy CFO of Fraud in H-P Deal. Justice Department Urges Alternative Remedies in AT&T-Time Warner Merger. Dairy futures. HNA, SkyBridge Drop Deal as Scaramucci Plans Return. BP’s Efforts to Get Back Among Big Oil’s Elite Start to Pay Off. The Real Risk Is Believing That Volatility Is Risk. New correlations spell concern for bond and equity investors. How Ferrero Rocher Became a Status Symbol for Immigrant Families. Manhattan District Attorney Cyrus Vance Jr. “is actually far more punitive toward poor and minority defendants than his counterparts in other boroughs.” For some reason “Fearless Girl” is at the Milken conference with a fake New York backdrop. Airport lounges are bad now. Renegade Tribeca dog-park privatization. Pug Terrorized By Phillie Phanatic While Trying To Enjoy Ballgame.

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