Why Swaps Holders Won’t Be Able to Pay You to Fail

(Bloomberg) -- If you’re carrying groceries across an icy street and two guys bet on whether you’ll fall, the one who thinks you will isn’t supposed to push you. But what if he pays you to take a tumble? A version of that question has been hotly debated within the $10 trillion credit-default swaps market. What’s at stake, however, isn’t just spilled milk, but potentially big payouts. Wall Street banks and hedge funds are closing in on a fix that they hope will put an end to a type of bet that some say is tantamount to rigging the market.

1. What’s this about?

Here’s the bet that sparked an industry-wide review: In 2017, Blackstone Group’s GSO Capital Partners agreed to extend financing to homebuilder Hovnanian Enterprises Inc. that included an unusual condition: Hovnanian had to miss an interest payment on a portion of its debt. That missed payment constituted a default that would trigger payouts on Hovnanian credit derivatives -- which would provide a windfall for GSO, which had bought the derivatives beforehand. To close the circle, GSO would use the payouts to subsidize the relatively cheap financing it was offering to the builder -- an apparent win-win. It was a new twist on a trade GSO tried with a Spanish gaming company in 2013 and revived debates over so-called “manufactured defaults.”

2. Wasn’t there a loser?

Yes. Credit-default swaps, which are essentially bets on whether a borrower will repay its debt, are binary. If there’s a default, buyers get paid by the sellers on the other side of the trade. In this case, Solus Alternative Asset Management sold credit-default swaps linked to Hovnanian. It cried foul and sued. Eventually, the two hedge funds announced a settlement under which Hovnanian made a payment it had missed, avoiding triggering the derivatives.

3. 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 used for hedging. That is, someone lending to a company would buy swaps that would let them recoup some of their loss if the borrower defaulted. As the market expanded, investors with no direct connection to a company might buy or sell swaps as, in effect, a side bet on its health. In either case, buyers of such swaps didn’t necessarily expect their wagers to have any direct impact on the borrower. The opening for manufactured defaults came as investors saw that they could dangle financing to companies in exchange for a strategic missed interest payment that could create a CDS payout.

4. How does that work?

You’d think it would be simple to determine if there’s a default -- that is, if the borrower skips an interest payment or otherwise fails to pay debt. But it’s proved far trickier. For example, in 2016, CDS players were split over whether iHeartMedia defaulted on its debt after repaying all but a small chunk of debt held by a subsidiary. In practical terms, a "credit event” is a default if the 15-member Credit Derivatives Determinations Committee made up of some of the market’s biggest players determines it is, in which case the swaps will pay out after a price-setting auction.

5. Could a trade like this happen again?

Maybe, but maybe not for much longer. A new plan from trade group the International Swaps and Derivatives Association is designed to prevent it. ISDA, working with Wall Street banks and hedge funds, has proposed amending the definition of “failure to pay” credit events that can trigger payouts to tie defaults more closely to a company’s actual financial condition and struggles. The panel that rules on defaults will look for signs that a company was in distress, like if the debtor had hired restructuring advisers or missed an interest payment after failing to refinance. If there’s evidence that a company agreed to skip a payment for the express purpose of benefiting CDS players, that wouldn’t meet the credit deterioration requirement.

6. Will this end all CDS shenanigans?

Unlikely. That would be underestimating the creativity of CDS players, or their lawyers. Industry watchers say the new rules could be a real fix to the manufactured-default problem, but hedge funds have found other, different ways to be innovative with credit-default swaps that the proposal doesn’t address. Hedge funds Aurelius Capital Management and Owl Creek Asset Management signed on to Neiman Marcus’s debt exchange proposal after the retailer tweaked documentation to tie more bonds to its CDS, effectively boosting the value of the swaps. Goldman Sachs Group Inc. got a struggling buyout loan from United Natural Foods Inc. done after adding terms that preserved the value of CDS linked to its acquisition target. Funds have also fought over derivatives tied to struggling newspaper chain McClatchy Co. and even Sears Holdings Corp. after it filed for bankruptcy last year.

7. What’s the case against these transactions?

Critics argue these deals 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 considered taking action against the controversial trades.

The Reference Shelf

  • ISDA’s proposed amendment to CDS definitions.
  • A review of some of the most creative CDS transactions in recent years.
  • The CFTC’s April 2018 statement on “manufactured credit events.”
  • Bloomberg Opinion’s Matt Levine has been exploring the wide world of CDS creativity.

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