Hedge Funds Said to Seek Fix of CDS Flaw Exposed by GSO Saga

(Bloomberg) -- A group of powerful hedge funds is banding together to repair the credit-default swaps market after a spate of manufactured defaults has threatened the usefulness of the product.

Elliott Capital Management and Apollo Global Management are among firms working on closing loopholes that have allowed investors to profit from engineering defaults on a company’s debt, according to people with knowledge of the matter. CQS and Anchorage Capital are also part of the group, the people said. Companies’ failures to make payments on their borrowings can trigger CDS payouts.

Investors have previously complained that these maneuvers spur defaults from companies that are still very much alive, when credit derivatives were meant to protect money managers against the borrowers’ demise. Those complaints are translating to action now after a controversial trade late last year from Blackstone Group’s GSO Capital, where it loaned money to Hovnanian Enterprises Inc. and planned to induce a default on a portion of that company’s debt.

GSO Agrees

The group is being shepherded by law firm Milbank, Tweed, Hadley & McCloy, the people said, asking not to be identified as the discussions are private. There’s no set deadline to come up with solutions, they said, and the negotiations are likely to be complicated by the fact that a number of the firms have found themselves on the opposite side of such situations. A representative for Elliott didn’t respond to requests for comment. Representatives for the other firms declined to comment.

Even GSO’s Bennett Goodman said in an interview last week that he backs and encourages any effort to change the rules.

Hovnanian is the latest but not the only example of a company carrying out a limited default. Radio operator iHeartMedia Inc., paper maker Norske Skog and Spanish gaming company Codere had all used various provisions to carry out a limited default on their debt.

Solus Responds

That has sparked an outcry in the market as money managers say the swaps are being used in a way that diverges from their goal of helping investors hedge their investments or find a way to express their view on the underlying company. While many firms have been having conversations with each other, this move represents a concrete effort to find ways to legally solve for this problem.

The International Swaps and Derivatives Association, the trade group, isn’t a part of this effort yet but any change will have to be driven through ISDA. The body has already said that it will “gather feedback from its members on whether further amendments to the definitions should be considered, especially with regards to engineered defaults.”

An unidentified party asked an ISDA committee on Tuesday about whether defaults engineered by a firm with a CDS position should trigger the derivatives.

Solus Alternative Asset Management wasn’t the firm that submitted the question to ISDA, according to Chris Pucillo, the founder of the firm. The hedge fund finds itself on the hook for the potential payouts on the Hovnanian contracts.

“Solus believes the question should be addressed as timely and relevant given recent events in the CDS market,” Pucillo said in a statement. “Such action by ISDA is especially important as the recently reported lobbying efforts to amend ISDA documentation, even if successful, would do nothing to prevent engineered defaults as to the vast amount of existing CDS in the market.”

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