Wall Street Wants to Reform CDS. Here's Why That'll Be Tough

(Bloomberg) -- Some of Wall Street’s biggest players are proposing a fix that they hope will reform a $10 trillion credit derivatives market that has become a hotbed of ruthless side deals and alleged manipulation. It may not be so simple.

The plan announced Wednesday is the market’s most ambitious effort yet to address the controversy that erupted last year after a refinancing deal involving homebuilder Hovnanian Enterprises Inc. GSO Capital Partners, a unit of Blackstone Group LP, agreed to lend money to Hovnanian on the condition that the company default on a small portion of its bonds, in an effort to trigger a payout on credit-default swaps (GSO ultimately settled the matter with a rival hedge fund that sued over the deal).

The International Swaps and Derivatives Association’s new guidelines could put the brakes on future Hovnanians in the CDS market, it’s only one type of deal that has drawn scrutiny in recent months.

“There’s a bit of a cat-and-mouse game between buyers and sellers,” said Athanassios Diplas, a former risk management chief at Deutsche Bank AG who now works as a derivatives consultant. “No matter how we write the definitions, they’re always going to try to find a way to go around them. That’s why the definitions have to be revisited every now and then.”

Complicating matters is that the panel that determines when CDS are triggered has been the subject of controversy itself. The so-called determinations committee, or DC, is made up of derivatives dealers and fund managers that often have trading positions in the matters that come before it.

“It could be a good solution if there’s enough confidence in the DC’s ability to get it right and to avoid controversy,” Julia Lu, a law partner at Richards Kibbe & Orbe LLP whose specialties include derivatives, said of the proposed fix. “The problem is going to be in any given situation there are different interests to be balanced against each other.”

A spokeswoman for ISDA declined to comment beyond its statement on Wednesday.

Here’s a look at the other controversial trades that have emerged in the year since Hovnanian kicked off the furor. Except for rare occasions where the matter ended up in court, the details are based on conversations with people who had knowledge of the trades but didn’t want to be identified discussing private transactions.


Chatham Asset Management approached McClatchy Co. last year with a deal that was hard to pass up. The New Jersey-based hedge fund agreed to lend the newspaper publisher $418.5 million so that it could pay down some outstanding bonds. Leading up to that deal, Chatham had been selling CDS insuring that debt. And when news of the loan broke, the value of its bets surged on the speculation that there soon would be no bonds left to insure (the new debt would have been placed in a separate unit and not linked to the CDS). Hedge funds that were betting on a McClatchy default, not surprisingly, grumbled. But then they effectively beat Chatham at its own game, offering McClatchy a sweetened refinancing deal that would create new bonds linked to their outstanding CDS contracts.

United Natural Foods

When Goldman Sachs Group Inc. struggled last year to find investors for a $2 billion loan backing an acquisition by United Natural Foods Inc., it managed to lure an unusual ally: hedge funds that had been betting against the target company using CDS. The transaction would have eliminated debt linked to the acquisition target, grocer Supervalu. That is, until Goldman agreed to tweak terms of the loans to make Supervalu a co-borrower.

The tweak, along with other concessions helped Goldman fill its order book. It also got the bank sued. United Natural Foods Inc. filed a lawsuit in January seeking at least $52 million, saying the maneuver exposes them to hedge fund sharks incentivized to see the company stumble. Goldman vowed to vigorously fight the case, calling it “entirely without merit.”


Bankrupt department-store chain Sears Holdings was at the center of perhaps the most mind-blowing fight over CDS payouts. Cyrus Capital Partners was believed by market participants to have made a massive wager that CDS tied to a Sears unit would -- despite the bankruptcy -- pay out very little in the end because debt issued by that unit had become scarce. A group of hedge funds that had bought default insurance, however, sought to change that. They convinced Sears to auction off an obscure set of internal notes that could be used to settle the CDS and, thus, boost the payout.

In a twist, Cyrus outbid the other funds in an effort to keep the notes out of its rivals’ hands. It also convinced Sears not to sell any more of the debt. The fight spilled into bankruptcy court and the rival funds won a re-do of the auction. But they ended up winding down their trades instead. Now, a committee of Sears creditors is investigating whether anything improper occurred around the transactions.

Neiman Marcus

The struggling luxury retailer, faced with accusations from a hedge fund that it may have violated debt covenants, sought to convince its creditors to eliminate that threat by exchanging their holdings for new debt. To help seal the deal, the company agreed to demands from hedge funds Aurelius Capital Management and Owl Creek Asset Management, who wanted to add some key language that could boost the value of CDS tied to Neiman.

The CDS prices indeed soared after the company announced the details of the exchange. Marble Ridge Capital, the hedge fund questioning whether debt covenants were violated, accused Neiman of striking a “devil’s bargain” with other funds betting against it. A representative for Neiman said this week that the objections came from “a small holder that clearly regrets it has refused the company’s repeated invitations to join creditor groups that reached” the exchange agreement. “The deal will help support the company’s long-term success,” the representative said.

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