(Bloomberg) -- Credit-default swaps are stirring controversy in markets again, a decade after they played a key role in the 2008 financial crisis. These contracts, known as CDS, are a type of insurance against a company or country defaulting. Now some hedge funds, as part of financing packages they extend to troubled companies, are pressing the companies to trigger or avert payouts on these derivatives, depending on what side of the trade the hedge funds are on. To critics, using CDS trades this way amounts to rigging an $11 trillion market.
1. How exactly does this work?
Here’s an example. Last year, Blackstone Group’s GSO Capital Partners extended financing to homebuilder Hovnanian Enterprises Inc. that included an unusual condition: Hovnanian had to miss an interest payment on a portion of its debt, a default that would trigger payouts on Hovnanian credit derivatives. This would provide a windfall for GSO, which had bought the derivatives beforehand and would use the payouts to subsidize the relatively cheap financing it was offering to the builder -- an apparent win-win. But Solus Alternative Asset Management was on the other side of credit-default swaps linked to Hovnanian, and was therefore in line to lose. It cried foul and sued. At the end of May, the two hedge funds announced a settlement under which Hovnanian made a payment it had missed, avoiding triggering the derivatives.
2. Is this what credit default swaps were invented for?
Not really. This type of derivative -- a contract whose value is derived from the movements of an underlying asset, index or instrument -- was originally viewed as a “side bet” on a company’s or country’s ability to pay its debt. Buyers of such swaps didn’t necessarily expect their wagers to have any direct impact on the company or country. Purchasers of a credit derivative, usually debt investors, make payments to a seller, who provides a payout if a borrower fails to make good on its obligations. If the borrower skips an interest payment or otherwise fails to pay debt, the International Swaps and Derivatives Association, a trade group, determines if the swaps pay out.
3. Who else is using credit-default swaps this way?
Hedge fund Chatham Asset Management is said to have sold credit derivatives while lending to McClatchy Co., the money-losing newspaper chain. The financing transaction is shifting the publisher’s debt to a new unit, ensuring that derivatives linked to the parent company’s debt will not pay out. That means Chatham wins its bet. In a similar vein, traders have speculated that Sears Holdings Corp. is working on a financing transaction that would benefit funds that are betting that a unit of the company stays solvent. In 2013, GSO lent to Codere SA on the condition that the gaming company delay an interest payment for two days, to trigger credit derivatives. In 2014, hedge funds lent to RadioShack Corp. to keep it afloat during the holiday season. That meant the funds profited on their bets that the electronics retailer would stay alive a little longer than others expected.
4. What’s the case against this type of deal?
Critics argue these transactions create an unacceptable wild card in the credit derivatives markets, and threaten to make the contracts almost meaningless. The U.S. Commodity Futures Trading Commission said in April that "manufactured credit events" like the CDS defaults may amount to market manipulation, and it’s considering take action against the controversial trades.
5. Why do these derivatives sound familiar?
Credit-default swaps date back to the 1990s and were pioneered by what is now JPMorgan Chase & Co. They played a key role in the runup to the financial crisis. Savvy traders and money managers used them to bet against the housing market, as documented in the book and movie “The Big Short.” American International Group Inc. used the derivatives to bet on subprime loans, a trade that forced the insurer into a U.S. bailout. Credit-default swaps were also packaged into synthetic collateralized debt obligations, or CDO, a type of instrument that the Financial Crisis Inquiry Commission found helped amplify the housing crisis.
The Reference Shelf
- Other creative financing deals are leading to court battles as well.
- From 1999, JPMorgan’s guide to credit derivatives.
- The CFTC’s April statement on "manufactured credit events."
- How Sears CDS prices plunged after a new proposal from its biggest shareholder.
- More on the McClatchy’s trade.
- Bloomberg Opinion’s Matt Levine has been exploring the wide world of CDS creativity.
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