Credit Derivatives Bring People Together

(Bloomberg Opinion) -- CDS: It works.

We talked a while back about McClatchy Co.’s proposed debt refinancing. McClatchy was going to refinance all of its debt, much of which was owned by hedge fund Chatham Asset Management, with some new debt, much of which Chatham was going to buy.

The trick was that none of the new debt would actually be issued by McClatchy: It would be issued by some new affiliate that didn’t count as McClatchy under the terms of credit-default swaps on McClatchy’s debt. This would leave McClatchy with no debt at all, for CDS purposes. (The new debt owed by the affiliate would still be McClatchy’s concern for most other practical purposes.) This would render its CDS worthless. If you had sold a lot of CDS, you collected a lot of premium, because McClatchy’s credit looked iffy and people were paying a lot for protection; if the trade went through, the value of that CDS would go to zero and you could just walk away and keep all of your premium.

Obviously Chatham had sold a lot of McClatchy CDS and stood to make a lot of money by doing this, some of which it was willing to share with McClatchy in the form of attractive financing.

But not enough! Here’s the latest on McClatchy, from Bloomberg’s Claire Boston and Sridhar Natarajan:

The struggling newspaper publisher proposed financings that will keep debt at the McClatchy parent company, counter to a previous plan announced in April to move most of its borrowings to a subsidiary. Its prior plan would have hurt the hedge funds that were using credit default swaps to short McClatchy’s borrowings. That sort of creative financing has grown more popular while also attracting controversy in the more than $10 trillion market for credit derivatives.

Hedge funds that stood to lose under the April proposal are at least partly responsible for the latest plan: they’ve offered to buy a chunk of the new bonds the company is selling, according to people with knowledge of the matter. By potentially buying the bonds, they would be funding the publisher while also maintaining their hope for a payout in the future if the money-losing company grows weaker. 

I just want to take a moment to appreciate the really beautiful sense of shared humanity and fellowship here, the ability of CDS—so often so maligned—to bring people together in a spirit of cooperation. It’s barely a month ago that the Pope was complaining about CDS, saying that “the spread of such a kind of contract without proper limits has encouraged the growth of a finance of chance, and of gambling on the failure of others, which is unacceptable from the ethical point of view.” And, you know: true! But here these gamblers were, betting on the failure of McClatchy, and they nonetheless came together to offer McClatchy new financing. It’s like a Christmas truce in the trenches, but of CDS. “We’ve had so much fun gambling on your failure,” the hedge funds almost said, “that we’d like to give you money to keep you from failing, so we can keep gambling on your failure.”

I mean, not quite; really they gave McClatchy money to prevent it from taking Chatham’s deal, which would have ended the gamble the other way, by permanently preventing McClatchy from failing. That looked to some people like cheating: Sure, yes, if you bet on McClatchy’s failure, you run the risk that someone will offer it an attractive refinancing and that it won’t fail—but you expect to at least be able to keep betting that it will fail to pay off that attractive refinancing. An attractive refinancing that moves all its debt elsewhere, voiding the bet forever, seems unfair. 

But that's not McClatchy’s problem. McClatchy’s problem was refinancing its debt. So if CDS-holding hedge funds came to it and said “your refinancing is not fair to us,” McClatchy could reasonably reply: Well, make us a better offer. In fact I wrote, back in May:

Oh by the way, if you are a CDS holder in McClatchy who is aggrieved that the proposed refinancing will leave your CDS worthless, you could always go to McClatchy and offer it a better refinancing deal than Chatham is offering, in exchange for it not rendering your CDS worthless. 

And they did! McClatchy will sell them (some of) its new senior secured notes, presumably on terms more favorable than it could have gotten with the Chatham deal (which also required a bond exchange offer); it has also amended its deal with Chatham

(I added back in May: “Even better, though, you could go to McClatchy and offer it a better refinancing deal, in exchange for doing a trivial default on its existing debt that triggers your CDS,” like Hovnanian Enterprises Inc. almost did. It is still my dream to see an auction like this, where CDS buyers and sellers bid to offer the company more favorable financing terms in exchange for the company hosing their counterparties. But McClatchy—where Chatham is already a big shareholder and creditor—was probably not the right venue for it.)

It is just magical, isn’t it? “By potentially buying the bonds, they would be funding the publisher while also maintaining their hope for a payout in the future if the money-losing company grows weaker.” What a wonderful sentence. They’re lending McClatchy money, hoping that it won’t be able to pay them back. (What does that mean for, like, the covenants?) They bet that it wouldn’t be able to pay off its debts, and now they are paying off its debts for it, to preserve the possibility that it won’t be able to pay off its debts.

We talk a lot about CDS gamesmanship around here, which I enjoy, because games are fun, and why shouldn’t finance also be fun? But this transcends the usual petty sort of gamesmanship in which CDS traders try to sneak one past each other; this game got so strange that the CDS buyers ended up switching sides and funding the company they had bet against. They came for a game of hide-and-seek and ended up in Narnia. “A finite game is played for the purpose of winning,” says James Carse, “an infinite game for the purpose of continuing the play.” This CDS game touched on the infinite.

(Oh by the way: Here I am writing about the CDS-buying hedge funds as though they “bet against” McClatchy’s credit. Presumably some of them did. But presumably other buyers of McClatchy CDS were just holders of McClatchy bonds who wanted to hedge them. Those investors would also prefer a refinancing that doesn’t orphan their CDS to one that does. You read sometimes about the “empty creditor” problem, where bondholders who have hedged with CDS have no incentive to help a company restructure its debt, because they get paid out on CDS if it defaults. Doesn’t that seem so naïve now? See, really, bondholders who have hedged with CDS have an extra incentive to help a company restructure, because if they don’t someone else might in a way that zeroes the CDS.)

Real-estate broker-dealers.

The idea is relatively simple: A house hunter hires FlyHomes as her broker. When she’s ready to bid on a home, she gives the startup a deposit of 5 percent of the bid price. FlyHomes then makes an all-cash offer for the property, using its line of credit from a bank. After the deal is done, it sells the house to the homebuyer once she’s gotten a mortgage. In return, the company earns the typical 3 percent commission from the original seller.

Every asset market has natural buyers (people who need houses) on one side and natural sellers (people who are leaving their houses) on the other. Some markets also have dealers, middlemen, people who buy from the natural sellers and sell to the natural buyers, who add liquidity and make the market function more smoothly and take a cut for themselves. One vague thesis of mine is that in markets without dealers, the main form of innovation is people inventing the concept of dealers, while in markets with dealers, the main form of innovation is people trying to get rid of dealers. So corporate bonds mostly trade through dealers, and there are dozens of startups trying to build “all-to-all” trading platforms to connect investors to each other directly and cut out the middlemen. Stocks, meanwhile, mostly trade on all-to-all exchanges where natural buyers can meet natural sellers—and so in fact many stock trades are intermediated by high-frequency electronic market makers (or wholesalers, or internalizers, etc.) buying from the natural sellers and selling to the natural buyers—and so there are dark pools and market-structure reform proposals designed to connect investors to each other directly, away from the high-frequency traders, and cut out the middlemen.

And houses mostly trade by house buyers buying from house sellers, which is inconvenient insofar as neither the buyers nor the sellers are well-financed fast-moving professionals. If you are a well-financed fast-moving professional, there is an opportunity there—to provide immediacy, as the jargon goes, and to charge for it—and so here we are. In a decade, maybe people will start building house dark pools where real sellers can sell to real buyers without high-frequency house traders taking a cut.

Blockchain blockchain blockchain.

The New York Times has blockchained quite a blockchain about blockchain, with a whole special blockchain blockchaining the blockchain of blockchain. “Blockchain is emerging from the shadows and making its way into a murky future,” it blockchains, which … are the shadows … not … murky? 

“Here are some of the most ambitious blockchain projects companies and governments are working on.” “Here is a look at some of the most influential people in the industry today.” Here is a story about how “more than 200 government agencies around the world, including the Department of Homeland Security, were exploring the use of blockchain." Here is a story about Overstock.com’s blockchain forays. Here is a list of crypto slang. Here is a Q&A about blockchains. Here is “A Field Guide to the Hurdles Facing Blockchain Adoption.”

And here is a claim that “If some financial institutions had used blockchains before the last recession, we may not have had one,” which caused me to throw my computer through a blockchain. If the Mets had used blockchain in 2015, they would have won the World Series! If blockchain had been the Democratic nominee in 2016, it would have won! If you put a thousand monkeys on a thousand blockchains, they’d write Hamlet! If your aunt had blockchain, she’d be your uncle! Blockchain!

The crypto.

“FBI Has 130 Cryptocurrency-Related Investigations, Agent Says,” is the headline here, and I guess if you are doing a shady crypto thing, the question to ask yourself is, “am I doing one of the 130 shadiest crypto things?” The odds are overwhelming that the answer is no, right? There are millions of people doing shady crypto things; what makes you so special that you’re in the top 130? You’re fine, 130 investigations is nothing. This is not legal advice, but if you’re doing a shady crypto thing, email me and tell me about it and I will bet you $5 that you are not being investigated by the FBI.

Everything is tech.

One aspect of, you know, late capitalism or whatever is that every taxicab company and consumer food company and real-estate brokerage and whatever else calls itself a “ tech company.” For the most part there is no reason to care about this. It’s just words. Nothing changes in the world if you say that the box of groceries that arrived at your door came from a “tech company” rather than a “supermarket.” Sure sure sure there is a notion that the word “tech” makes these companies more attractive to venture capitalists and gets them higher valuations, but you have to be a real efficient-markets nihilist to worry too much about that. (Do the VCs really not know that their favorite coffee company sells coffee?) 

Still, many aspects of reality are organized by linguistic categories, so there are some real-world consequences. For instance, to take one dumb example, investment bankers whose business cards say “Tech” (or, commonly, “Technology, Media & Telecoms”—because the entrenched categories are old) will be very busy advising taxi and grocery companies, while investment bankers whose business cards say “Industrials” or “Consumer & Retail” or whatever will find that all of their clients have vanished. Eventually the banks will catch on, though, and the categories will change:

JPMorgan Chase & Co. is reconfiguring its investment-banking operations in China ahead of anticipated regulatory changes and a swell of new business.

The bank is changing how it categorizes its teams of bankers, formerly assigned to sector groups such as health care and industrials, said John Hall, JPMorgan’s co-head of investment banking coverage for Asia Pacific.

The bank in recent weeks has created seven new groups underpinned by the technology sector. They include financial services and technology, encompassing blockchain and mobile-banking clients, and new mobility, including bike-sharing companies.

They got rid of all the sector groups and put everyone in tech. And then they set up seven new sector groups, all of which are tech. 

Prime bank scam!

My favorite scam is the “prime bank scam,” which combines conspiracy theory and financial gibberish and world-building worthy of “The Sting” into a grand scam that doesn’t just take your money but alters your perception of reality. And here is a delightful John Gapper story about a prime bank scam that some people ran on a Dutch shipping tycoon:

As construction of Pioneering Spirit started in 2011, he was lured by Sultana, Rejniak and others to hand over €100m that he had raised for the ship in a get-rich-quick investment scheme. He thought he was being granted access to a secret trading opportunity offered to high net worth individuals by the US Federal Reserve central bank, supposedly supported by the Vatican bank and the UN. He ended up having €12m stolen.

The story was ridiculous, differing only in its scale and exotic nature from countless others that offer “privileged” victims fabulous rewards. “It was bizarre, but it was brought to us in an extremely smart way. We were defrauded by very clever people,” Heerema told me at the main engineering office of his company Allseas in Delft, near Rotterdam, which is lined with photos and memorabilia of his late father and their ships. “You always hear that about fraudsters, don’t you? They are charming people who know how to talk [others] into things. Later you say, ‘My God, how could I have?’”

The great mystery, in these scams, how the accretion of unrelated details could help convince the victim. Like:

Con man: This is a special opportunity offered by the Federal Reserve.

Mark: Really? Sounds suspicious. Do you have any proof?

Con man: Also the Vatican Bank.

Mark: Oh well in that case … 

Con man: And the UN somehow.

Mark: Here is all my money.

The point here is not to advance rational evidence that this opportunity is real; the point is to paint an increasingly grandiose picture of a magical world to which the mark is being offered access. You don’t really want to convince him that he’ll make money, because he doesn’t really want to make money. You want to convince him that somewhere, just out of view, people are living enchanted lives, that Jay Powell is partying with the Pope, that he is special enough to join that world and that you can be his guide there. The model is not a bond prospectus, it’s “The Da Vinci Code.” It’s great stuff. Anyway Gapper’s story is not so much about the scam but about how the mark got really mad and took his vengeance and now the con men are serving lengthy prison sentences.

Goldman.

David Solomon is in most respects a pretty traditional choice to be chief executive officer of Goldman Sachs Group Inc.: He’s bald, gravelly-voiced, experienced in banking and capital markets, etc. And yet I cannot shake the feeling that “Goldman's CEO-in-waiting just released his first electronic dance single, a remix of a popular Fleetwood Mac song and it's already a hot song of the summer on Spotify” is just a very 2018 headline. The song is “Don’t Stop,” which arguably conflicts a little with Solomon’s efforts to get Goldman’s junior bankers to work less. If I were still a Goldman vice president, I’d leave that song playing on my computer speakers when I left for the night. “DJ D-Sol’s song is right you know,” I would say to the analysts, as I walked out the door. 

Elsewhere in public-company CEO hobbies.

Continuing the theme of extremely 2018 headlines, here’s “Elon Musk drawn into farting unicorn dispute with potter.” O [sighs continuously for 12 hours] kay.

Things happen.

Powell Wants ‘Real Economy’ to Guide Fed. Lyft Valuation Hits $15 Billion With Boost From Fidelity. “The fallacy is that the companies with the most debt are the most leveraged.” BOE Warns of Growing Risks in Global Debt Markets. SEC Poised to Advance ETF Approval Rule Long Sought by Industry. The Consultants Are Eating Madison Avenue’s Lunch. Elon Musk Races to Exit Tesla’s ‘Production Hell.’ “I successfully applied to multiple Care.com babysitting jobs as Harvey Weinstein.” Clickbait research notes. Woman who called cops on black girl selling water resigns as CEO of pot company

©2018 Bloomberg L.P.