CDS Creativity Is Everywhere

(Bloomberg Opinion) -- CDS manipulation?

Here’s a hypothetical situation for you. Let’s say Company X is in bad shape: It has a lot of debt, its business isn’t doing great, and it is running out of cash. It is likely to default on its debt in the next few months. In desperation, it sounds out financing options, but no one is all that keen to lend it any more money since there is no clear path to getting paid back. Credit-default swaps on Company X trade at distressed levels, say 40 points upfront—you have to pay $40 to insure $100 of debt for one year—reflecting the market’s expectation that default is likely and that recoveries in default would be low. 

Hedge Fund Y notices that Company X CDS is expensive and starts selling a bunch of it. People keep giving it $40 to insure $100 worth of debt for one year, which they think is a good trade because Company X is in such bad shape. Then, after selling a bunch of CDS, Hedge Fund Y springs its trap. It calls up Company X and asks, “would you like to borrow some money?” “Sure,” Company X says, “that is exactly what we want, but no one will lend us any.” “We will,” says Hedge Fund Y. “What’s the catch,” asks Company X. “Well,” says Hedge Fund Y, “what we really want is for you not to default on any of your debt for the next year.” “That’s not a catch at all! That’s what we want too,” says Company X. “Great,” says Hedge Fund Y, “so why don’t we lend you enough money that you’ll definitely be able to pay your bills for at least, say, 13 months.” “Sounds good,” says Company X; “if you do that we are confident that we will pay all our bills for at least, say, 13 months.” 

Company X now has money to keep operating, and to hire new staff and try to turn its business around. Hedge Fund Y now has a pretty nasty piece of paper, a loan to Company X that, when it comes due in 13 months or whenever, may very well not get repaid in full. No one other than Hedge Fund Y would have made that loan, which is worth nowhere near the amount of money that Hedge Fund Y loaned to Company X. But it can console itself with all those $40 checks that people kept writing it to buy one-year CDS on Company X. Assuming—and it’s the assumption of the hypothetical so just go with it—that Company X really doesn’t default in the next year, because of the help that Hedge Fund Y gave it, then all that one-year CDS will expire worthless, and all those CDS premiums will be free money to Hedge Fund Y. If the free money that Hedge Fund Y made from writing CDS outweighs the money that it loses by making the loan, then it’s a good trade.

Is this … bad? There is an obvious argument that it is good. Poor struggling Company X, which employs thousands of people in good middle-class jobs and makes widgets that many people purchase and treasure, has been given a lifeline. Its employees can keep their jobs a while longer, its customers can keep buying the widgets they crave, and who knows, maybe it can actually use that extra time to turn its business around and get out of its financial difficulties. 

There is one strong argument that it is bad, which is that it is economically inefficient. Creative destruction, don’t you know. Companies that cannot cover their cost of debt should restructure that debt, and maybe go out of business. Kicking the can down the road with a creepy derivatives-subsidized trade like this misallocates resources that could be more productively deployed elsewhere. All those Company X employees, who won’t get laid off because of the magic of the CDS market, aren’t really any better off: They’ll probably be laid off in a year anyway, and they’ll have delayed an opportunity to retrain and get a better job. This argument may be better or worse depending on the specifics of Company X’s situation—maybe its widgets are truly beloved and its sales are down due to a global financial crisis; maybe it is in a dying business and can never recover—but as a generic argument about how capitalism works it has some force.

There are other arguments that it is bad, arguments that are specifically about the CDS market, but these are I think much worse arguments. Here are three:

  1. It is insider trading. Hedge Fund Y knew it was going to offer this deal to Company X, and so when it sold CDS protection it had inside information that the rest of the market didn’t have. You could imagine some version of this story where it really would be illegal insider trading: If Hedge Fund Y went to Company X, and negotiated the loan, and was about to sign it, and said “hey hang on can we wait a week while we sell a bunch more CDS,” then that would look a lot like insider trading. But that is not my story. And if Hedge Fund Y knew only its own intention to offer this trade—and intuited that, in its desperate circumstances, Company X would be likely to take it—then it seems to me that that is not insider trading. Hedge Fund Y knew nothing that anyone else didn’t know, other than its own intentions, and you are generally free to trade on your own intentions.
  2. It is market manipulation. No one really knows what “market manipulation” is, so there’s always some chance that it is this. I don’t think so. I have argued in the past—about a similar trade—“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.” Hedge Fund Y didn’t manipulate CDS prices here, and after its intervention CDS prices correctly reflect the fact that Company X’s risk of default actually went down.
  3. It undermines confidence in the CDS market. It is true that if you buy CDS to speculate on Company X’s default, and then Company X doesn’t default, you will feel sad. (If you buy CDS because you own Company X bonds and you want to hedge, and then it doesn’t default, then you will feel indifferent; that is what hedging is.) If it doesn’t default because of the actions of a CDS seller, you might even feel a bit ripped off. This, I would argue, is mostly a problem with your feelings, not with CDS. When you buy CDS for speculative purposes, you are speculating (1) that the company won’t itself generate enough money to pay off its debts and (2) it will not be able to refinance them. If you are wrong about point 2, then … you were wrong? Like, your bet failed to work out because you assessed the company’s credit, broadly defined, incorrectly. The CDS market worked fine.

That concludes this hypothetical situation.

Meanwhile, Sears Holdings Corp. is considering a proposal from Eddie Lampert’s ESL Investment Inc., its biggest shareholder, in which ESL would buy Sears’s Kenmore brand and some other assets, and Sears would try to retire about $1.2 billion of debt by exchanging it for stock or buying it back at a discount for cash, using the proceeds of the asset sale. Sears is perpetually in not-so-great shape, and Lampert’s proposal is controversial and raises obvious conflicts of interest, but you can see how raising cash and paying off debt would be a good thing for a struggling retailer. The stock is up about 12 percent in the month since Sears announced the proposal, suggesting that shareholders think this might keep Sears going a bit longer.

Meanwhile Sears’s credit-default swap prices have plummeted: One-year Sears Roebuck Acceptance Corp. CDS traded at about 33 points upfront before the proposal was announced, but are down to about 9 points as of yesterday, according to Bloomberg data. (Five-year CDS went from about 49 to about 27.) This makes sense: Shareholders think the proposal might work and help Sears’s financial position, so why shouldn’t CDS traders think much the same thing and reduce the price they charge to hedge Sears debt?

But there is an alternative explanation, from Bloomberg’s Claire Boston  and Sridhar Natarajan:

Traders are now betting that the suggestion is an example of a creative financing transaction, where fund managers lend to companies under terms designed to create big profit for the funds’ side bets in credit derivatives, according to market participants with knowledge of the matter. Such financings have grown more popular over the last year, with newspaper publisher McClatchy Corp. and homebuilder Hovnanian Enterprises Inc. having agreed to them. …

In the case of Sears, traders are wagering that ESL will follow through on its proposal, and the department store will buy back or swap what had been its cheapest debt. A company’s lowest-priced debt is typically used to determine payouts on credit derivatives, so retiring the borrowings could translate to bigger profits for hedge funds that bet on a Sears unit staying solvent for the next year by selling default insurance contracts. 

The implication is that some of the financing for Lampert’s proposal might come from hedge funds who have sold CDS on Sears. Without this trade, there would be a good chance of a Sears default, and if Sears does default then its CDS will pay out based on the value of its cheapest debt, and that debt is pretty cheap and so the CDS sellers will be on the hook for a big payout. But with this trade, the chances of default (arguably) go down, and if there is a default then that cheapest debt will either be gone (because Sears has bought it back or equitized it) or at least more valuable (because Sears will push up the price by buying some back), so the CDS sellers will have less to lose. Or, of course, because this is all reflected in CDS prices now, the CDS sellers could just buy back their CDS at a profit now and not have to worry about default.

This is a variant on my hypothetical, and like most of the actual variants that you see in the news, it looks “worse.” (I mean, the RadioShack trade wasn’t really worse.) Here, the trade doesn’t just offer Sears a straightforward reprieve with new financing; it also involves Sears buying back its cheapest-to-deliver bonds in order to reduce the CDS payoff if it does default. (Though, if it does default, it is not obvious that the longer-dated bonds will still be cheaper than the rest; default tends to flatten out differences among a company’s bonds, as interest rate and maturity no longer really matter in bankruptcy.) That seems a bit more engineered than my hypothetical, and so might raise more eyebrows. There are examples that are “worse” yet: The McClatchy trade, which we have discussed, involves a CDS-seller hedge fund offering financing to the company to buy back all of its debt, and issue replacement debt out of a subsidiary that wouldn’t “count” as McClatchy for CDS purposes. The CDS would be orphaned—it wouldn’t refer to any debt anymore—so it could never be triggered, no matter how much trouble the company gets in into the future. Again this feels more engineered, more like a gaming of the CDS rules than just a loan to a troubled company. And trades like Codere and Hovnanian, which come from the other side—where CDS buyers offer a company financing in exchange for it agreeing to do a quickie default—feel even more like gaming the system, and tend to make everyone, from Goldman Sachs to the Pope, mad.

But I tend to be a defender around here of “creative” CDS transactions, not only because what higher form of human achievement could there be than creative derivatives transactions, but also because it seems to me that the boundary between “creative” CDS transactions and normal financing transactions is more porous than a lot of people think. The McClatchy trade is pretty close to the mooted Sears trade, which is pretty close to my hypothetical, which I think is fine.

Maybe you don’t; maybe you think my hypothetical is also bad. But then let me give you a further hypothetical: Instead of selling CDS on Company X, imagine that Hedge Fund Y had just loaned Company X a lot of money. In this scenario, Hedge Fund Y offers to lend Company X more money to avoid default, not to affect the prices of CDS, but just to try to keep Company X afloat so that it can try to turn its business around and pay off Hedge Fund Y’s original loan. That scenario is just the most normal thing in the world. That’s how banks and lenders operate all the time: When their borrowers are in distress, they extend or modify loans in order to relieve that distress and increase their chances of getting paid back. Sometimes this works and is good; sometimes it doesn’t work and is economically inefficient and gets referred to by names like “extend and pretend.”

But no one doubts that it is legitimate. It’s how credit markets are supposed to work: Creditors of a company that runs into trouble are supposed to work with the company to maximize its value as a going concern. But it’s also how derivatives markets are supposed to work: Derivatives are synthetic versions of real transactions, and CDS sellers are synthetic lenders to a company, so it’s perfectly reasonable that when the company runs into trouble the CDS sellers would act like lenders and try to keep it afloat.

Main Street Investors.

Here is a funny article about a new organization called “Main Street Investors,” which will be run by a former Trump aide and will be “housed inside the National Association of Manufacturers.” Its goal is apparently to outflank big institutional investors that vote for shareholder proposals demanding that companies do stuff like consider climate-change risks and disclose corporate lobbying, with the argument that these proposals are not actually good for the ultimate investors whose money is being run by the big institutions. From its FAQ:

Although Main Street investors control the single largest pool of equity capital in the world, they have virtually no ability to influence the way their money is being spent, and no say whatsoever on how shareholder proposals are being voted on in their name. That’s because most retail investors typically own shares in companies through a mutual fund within their 401(k), or individual retirement accounts or pension funds. If a retail investor is unhappy with how their money is being managed, or concerned the fund managers might be prioritizing pet political causes at the expense of generating optimal returns, currently there’s not a whole lot they can do about it. The goal of the Main Street Investors Coalition is to give these investors a voice in determining how their money is being leveraged.

There is something plausible-sounding about this: If you are the ultimate owner of some of the stock held by a BlackRock Inc. mutual fund, why shouldn’t you get to decide how that fund votes your share of the stock? It’s your money after all. But of course if you are the ultimate owner of some of the stock held by a BlackRock mutual fund, why shouldn’t you get to decide whether BlackRock sells that stock and buys some different stock? The answer is, duh, you bought a mutual fund: You recognized that it might be better for you—in terms of diversification, stock-picking skill, trading costs, time management, etc.—to give your money to professionals and let them decide how to invest it. It seems likely that the same argument would apply to voting. You may think that you want to rein in those overbearing liberals at BlackRock and decide how they vote with your money on climate-change resolutions, but after your two hundredth time voting your 0.05 shares on a shareholder proposal to split some company’s chairman and CEO jobs, you might conclude that this stuff should be left to professionals.

Of course one assumes that Main Street Investors will not really be in the business of trying to get institutions to offer pass-through voting to their investors, and that the goal will be more like lobbying to clamp down on shareholder proposals and institutional voting generally, on the theory that institutions are voting for “pet political causes” rather than for shareholder value maximization. (“Of course, fund managers will never admit that – they’ll always say that the motivation driving every decision they make with your money, every company or project they’re investing in, every shareholder proposal they’re voting on, is all about generating higher returns,” says Main Street’s FAQ.) The interesting development will be if this (pro-corporate, anti-environmentalist, etc.) group makes common cause with the more left-ish critics of institutional investors who worry that they create antitrust problems. Having most of corporate America controlled by a handful of giant institutions: It makes a lot of people nervous.

Fannie and Freddie.

I don’t make a lot of predictions around here, but one of my best, longest-running, perpetually renewed, and ever-so-slightly contrarian predictions is that, at any point, nothing will happen to Fannie Mae and Freddie Mac. Fannie and Freddie have been in a conservatorship run by the U.S. government for almost 10 years, and for most of that decade people have been running around saying things like “this is unsustainable” and “the government can’t own them forever” and “we need to get private capital back into the mortgage market” and I am always like, well, why? The status quo is good for the government, which gets a stream of profits from Fannie and Freddie while also being able to use them as a tool of housing policy. And consumers are able to get 30-year fixed-rate mortgages, and investors are able to get government-ish-backed mortgage bonds, and the system that everyone got used to before 2008 more or less continues. Re-privatizing Fannie and Freddie in some form, or getting rid of them, would require the government to make hard policy choices that would be challenged on every side. Also you know the government is busy. 

So every time someone introduces a bill, or sends around a PowerPoint deck, or whatever, about doing something to change the Fannie/Freddie status quo, I always laugh and think “sure sure” and then watch confidently as it goes nowhere. 

Here's Bloomberg’s Joe Light with the latest update:

Last month, Trump’s administration effectively acknowledged that it’s no closer to figuring out what to do with Fannie and Freddie. Treasury Secretary Steven Mnuchin said there’ll likely be no end to federal control during this Congress. In the meantime, the duo has only become more crucial to America’s booming-again housing market, standing behind about $5 trillion of loans.

Trump’s team hasn’t decided how to restructure the companies -- or even who should do it, the White House or Congress. It’s still in the earliest stages of figuring out what a new housing-finance system should look like, according to interviews with officials inside and outside the administration. Some of them likened the process to Groundhog Day.

Yeah, no, 10 years in, they’re not actually “in the earliest stages of figuring out what a new housing-finance system should look like.” They are in the middle stages of not figuring out what a new housing-finance system should look like. And it’s not like Groundhog Day. It’s just like … a day. It’s a normal day in which Fannie and Freddie are agencies of the U.S. government. That’s what the days are like now. Occasionally you can still get people to pretend that this is an abnormal situation, but as it keeps going on that becomes a more and more untenable position. In 50 years, sources in President Donald IV’s administration will say very seriously that they are in the earliest stages of figuring out how to get Fannie and Freddie out of conservatorship, but no one will believe them.

People are worried about loan market liquidity.

Why not? Here’s Alexandra Scaggs worrying that “there are currently five ETFs that invest in leveraged loans,” and that these exchange-traded funds with intraday liquidity have a mismatch with the illiquid underlying loans:

The problem with using liquid open-ended vehicles (like ETFs and mutual funds) to invest in illiquid assets is not as dry as settlement time. Instead, it is the chance that a negative feedback loop will occur if this currently booming market turns sour. If poor performance in these funds lead to withdrawals, that could lead to even worse performance, and more withdrawals, and so on.

In short, they create the risk of a fire sale ....

It is more niche than the bond-market one but it is basically the same worry. You don’t hear so much about that one anymore, in part because bond ETFs have seen some big withdrawals without any noticeable fire sales. But that doesn’t mean that the loan one is wrong. You could have a plausible frog-boiling model of liquidity mismatch in which people first started ETFs to trade stocks, where the liquidity mismatch was small, and that was fine, and then they moved into investment-grade bonds, where it was a bit bigger, and that was fine, and then high-yield bonds, and then loans, and then cryptocurrencies, and eventually there will be an ETF that owns like a portfolio of local hardware stores in Ohio and when it faces withdrawals it won’t be able to get liquidity at any price. If taking a risk works out well, you might forget that it is a risk at all, and move on to taking bigger and bigger versions of that risk until it finally does go wrong.

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