High yield debt and CDS market - Wild West!

[valueorama]

This is some disturbing turn of events that i feel will kill the CDS market or at least new versions of contracts need to be drafted.

 

===================

from FT:

 

https://www.ft.com/content/69194bda-f5af-11e7-88f7-5465a6ce1a00

 

Blackstone-led debt deal sparks outcry

Traders say refinancing of a US housebuilder undermines legitimacy of $5tn CDS market

 

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Joe Rennison in New York

an hour ago

34

 

Derivatives traders are crying foul over a Blackstone-led refinancing deal for the US housebuilder Hovnanian, saying the controversial arrangement threatens to further undermine the shrinking market for credit default swaps.

 

Hovnanian, which is based in New Jersey and is one of America’s largest homebuilders, has agreed with Blackstone-owned hedge fund GSO to refinance up to $320m of its debt — but the deal has a catch.

 

In order to secure the funds from GSO, Hovnanian has agreed to skip a payment on some of its existing bonds, triggering a technical default and a big payday for the hedge fund, which placed bets on a default in the CDS market.

 

While legal, traders say the arrangement makes a mockery of a market designed to be used to hedge the risk of real defaults at companies in genuine financial distress.

 

“We fear that the Hovnanian situation could embolden investors to pursue manufactured credit events with other corporate issuers, which would undermine the true intention and spirit of the CDS market,” said Adam Savarese, co-head of leveraged finance trading at Goldman Sachs.

 

GSO is able to offer attractive financing terms precisely because they stand to receive a payout on its CDS contracts, and because they have structured the proposed new lending to maximise that payout. Others, including Goldman and credit hedge funds Citadel and Solus Alternative Asset Management, are on the other side of the CDS contracts and stand to lose money, according to people familiar with their positions.

 

“You can do your credit work but you may not know what is going on behind the scenes where someone could be trying to manufacturer a credit event,” said another fund that had sold Hovnanian CDS.

 

Solus on Thursday launched a lawsuit against GSO and Hovnanian, asking for an injunction to stop what it called “an illegal bribery scheme masquerading as a ‘refinancing transaction’”. Goldman and Solus had earlier offered Hovnanian an alternative refinancing deal.

 

Hovnanian’s investors face a deadline of this Friday to give a green light to the GSO plan, although it also rests on the approval of a market committee of banks and credit investors, which will have to certify an event of default to trigger the CDS payout.

 

The tactic of making refinancing conditional on triggering CDS has been used on occasion before, although the Hovnanian situation is unusual because of the size of the deal and because the company is not in financial distress, according to analysts and traders.

Recommended

 

    Why does the CDS market leave so many people unhappy?

    The Big Read: Blackstone’s struggle to win over investors

    FT Series: Outlook for markets in 2018

 

CDS fell out of favour after the credit crisis and trading has further shrivelled as market players complain about a lack of transparency and liquidity. The value of outstanding “single-name” CDS, designed to hedge the risk of default on individual companies, has fallen from $33tn in November 2008 to $5tn in the middle of 2017, according to data from the Bank for International Settlements.

 

GSO and Hovnanian say their deal represents the best financing that was available to the company for replacing debt coming due in 2019. “The company appropriately utilised the most attractive financing techniques available,” said a GSO spokesperson.

 

But Peter Tchir at Academy Securities, who spearheaded the use of CDS during the early 2000s, said the controversy would have an impact on the market. “CDS was never designed for something like this,” he said. “I think this is going to create more and more pressure to create a better synthetic hedging vehicle than CDS.”

 

[Cigarbutt]

Thanks for the link valueorama.

The CDS market has been declining.

Is it because it is no longer a useful tool? because of the legal uncertainties tied to the default definition which is really a misnomer, or because there is simply less emphasis on credit risk? 

 

The specific issue mentioned in the article is similar to previous interpretation issues raised before between the risk "shedder" and the risk "taker".

It seems that the ISDA modified the master agreement (specific section on definition of default) along the way since the introduction of the product in the 90's.

Perhaps just noise?

 

[valueorama]

I think, CDS market is shrinking because of liquidity issues. Even on a good day, not all HY bonds trade. With CDS, it is even less.

 

1. To me, the situation described sounds like  insider trading.

2. or you can say, GSO basically got free money.

 

If the scenario mentioned in the article is considered, i would say the CDS is grossly under-priced.

 

ISDA should include language to remove these incentives. Otherwise, single name CDS market will be dead soon.

 

[HJ]

Thanks for the link valueorama.

The CDS market has been declining.

Is it because it is no longer a useful tool? because of the legal uncertainties tied to the default definition which is really a misnomer, or because there is simply less emphasis on credit risk? 

 

The specific issue mentioned in the article is similar to previous interpretation issues raised before between the risk "shedder" and the risk "taker".

It seems that the ISDA modified the master agreement (specific section on definition of default) along the way since the introduction of the product in the 90's.

Perhaps just noise?

 

CDS is and always has been simply a side bet, where the shorts and longs manipulate for gains.  It doesn't serve a financing need of the underlying economy.  And as Munger suggested, it probably shouldn't exist.  The rule of the game was always "make it up as you go".  The more mathematically inclined may find beauty in a theoretical pricing model, but it serves very little real life purpose.  Why would a bank buy credit protection?  Because they are too long on a credit.  Well, instead of lending too much to that borrower and then hedging it, maybe you shouldn't have lent this much to start with.  You say OK, I didn't realize I'm too long until after too much credit was extended, so now I need CDS.  But then why buy protection?  If you don't think you should lend this much, sell it for cash.  The only reason you would still keep it, but buy CDS is because you don't like the price, and buying protection allows you to not realize that full loss right at that moment of realization.  Now both sides have all the incentive to manipulate that CDS pricing for gains for as long as the contract is outstanding.  It's not a real or fair market by any stretch of the imagination, and never has been.  It's caveat emptor all the time for those who want to be involved. 

[TwoCitiesCapital]

I think, CDS market is shrinking because of liquidity issues. Even on a good day, not all HY bonds trade. With CDS, it is even less.

 

1. To me, the situation described sounds like  insider trading.

2. or you can say, GSO basically got free money.

 

If the scenario mentioned in the article is considered, i would say the CDS is grossly under-priced.

 

ISDA should include language to remove these incentives. Otherwise, single name CDS market will be dead soon.

 

Many CDS are MORE liquid than the underlying credits. This is especially true of the CDX indices.

 

Thanks for the link valueorama.

The CDS market has been declining.

Is it because it is no longer a useful tool? because of the legal uncertainties tied to the default definition which is really a misnomer, or because there is simply less emphasis on credit risk? 

 

The specific issue mentioned in the article is similar to previous interpretation issues raised before between the risk "shedder" and the risk "taker".

It seems that the ISDA modified the master agreement (specific section on definition of default) along the way since the introduction of the product in the 90's.

Perhaps just noise?

 

Why would a bank buy credit protection?  Because they are too long on a credit.  Well, instead of lending too much to that borrower and then hedging it, maybe you shouldn't have lent this much to start with. 

 

Instead of considering it "lending too much" we could consider it making a market. They transact to make the market - they hedge it so those activities don't kill them - and the sell it to free up the capital to do it again. This increases liquidity and price discovery. Similar to how the advent of the MBS allowed banks to make more mortgages and dropped the cost for home buyers.

 

[TwoCitiesCapital]

But very interesting article. Reminds me of the ECB structuring Greece's default in such a fashion as to avoid CDS payouts or the hedgefunds who owned Radio Shack stock forcing it into bankruptcy so they could get paid on the CDS they owned on RS debt.

 

Each year, the CDS market gets a bit more corrupted from its purpose with each manipulation shaking the confidence of investors trying to use it for its initial intention of hedging. I wish the regulators/courts/clearing houses/ISDA would step in and fix some of this shit :/

[Cigarbutt]

Historically, looking at the evolution of high yield spreads, there have been times when the default definition or the contract terms didn't need to be interpreted.

 

Funny, at a time when I find it may be useful to insure against credit risk (premiums appear low), I find that some suggest that high yield bonds were a good investment 10 years ago (fact) and may still be a good idea now (hypothesis) as spreads and volatility are reaching historical lows.

 

With long term thinking and with risk-free interest rates where they are, junk bonds look relatively cheap! Fascinating.

 

https://www.lordabbett.com/en/perspectives/marketview/us-high-yield-news-spreads-ten-years-later.html

[Cigarbutt]

Follow-up.

https://www.bloombergquint.com/markets/2018/04/11/solus-says-it-may-buy-hovnanian-bonds-to-cut-loss-from-gso-trade

 

Need clear rules for transparent price discovery.

[HJ]

Here's another one.  All these sophisticated hedge funds are getting their heads handed to them on finance 101.  Swaps are private contracts.  Not a security, and doesn't benefit from any of the protections a security offers an investor.

 

 

(Bloomberg) -- It seemed like a sure-fire bet: short the debt of a highly leveraged newspaper company that’s losing money. And for a while, it worked as investors piled up almost $500 million of wagers by buying credit-default swaps on the publisher, McClatchy Co.

That is until hedge fund Chatham Asset Management stacked the deck with a deal that’s threatening to make those swaps all but worthless.

The McClatchy situation is the latest trade that’s drawing jeers from critics who say the $11 trillion CDS market has devolved into a haven for manipulation. One regulator has already warned it’s looking at practices in the market after another trade by Blackstone Group LP’s credit arm that would engineer a default by a homebuilder and allow it to collect on $333 million of CDS.

“CDS is being manipulated to the point that it potentially invalidates the product,” says Mike Terwilliger, a money manager at Resource America Inc. “Fundamentally, markets rely upon valid prices. How can I use a product if I need to worry that counterparties are trying to vandalize capital structures to contort CDS contracts?”

Gold Rush

In the McClatchy trade, New Jersey-based Chatham struck a deal with the newspaper publisher -- founded in California on the heels of the Gold Rush -- to refinance most of its $710 million of debt with two new loans. The loans will allow the company to trim about $50 million off its most expensive bond and give it a few more years to repay the bulk of its debt. The news did little to boost McClatchy’s $72 million market cap. But because of a condition in the deal with Chatham that would move McClatchy’s borrowings into a new wholly owned subsidiary, the impact was seismic for holders of the derivatives.

In a matter of hours, the refinancing wiped out 70 percent of the market value of a five-year CDS on McClatchy, data compiled by Bloomberg and price provider CMA show.

That was bad news for the hedge funds, banks and other investors that had bought insurance against a McClatchy default. Because the new debt would be shifted away from the parent and into the new unit, it’s fueling speculation that the Chatham deal will create what’s commonly known in the CDS world as an orphaned contract. In other words, anyone who bought insurance on a McClatchy default would effectively be paying insurance on an entity with no significant debt.

But for Chatham, the deal could bring a potential windfall. Leading up to the deal, Chatham had been selling swaps insuring against a default by McClatchy. So if the transaction were to be completed, it would be getting paid CDS premiums to guarantee against a default that could never technically happen.

A spokesman for Chatham declined to comment. A representative for McClatchy, which owns newspapers including the Miami Herald and Sacramento Bee, didn’t respond to requests for comment.

“It’s 100 percent fair to take the opposite side of a trade,” said Jochen Felsenheimer, the Munich-based managing director at XAIA Investment GmbH. "But if then you do something bilaterally with the company, that isn’t a fair trade.”

In addition to the CDS trades, Chatham had been snapping up McClatchy bondsfor months, collecting $356 million of its $365 million of debentures. The buying drove the price of one of those bonds -- those maturing in 2029 -- to 125 cents on the dollar, making it the best performer in a Bloomberg Barclaysjunk-bond index this year. McClatchy has said the loans will be priced relative to the fair trading value of the bonds, which means Chatham may be issued the loans at a premium to par, the publisher’s executives said on an earnings calllast week.

The deal is still contingent on McClatchy’s ability to refinance almost 300 million of first-lien bonds due in 2022 that Chatham doesn’t own.

Reverse of Hovnanian

In many ways, the McClatchy deal could shape up to be the opposite of the Hovnanian Enterprises Inc. trade orchestrated by Blackstone’s GSO, which hasgripped the derivatives market for months.

GSO has been embroiled in a lawsuit over its maneuver with the New Jersey-based homebuilder over the trade. The Commodity Futures Trading Commission last week sent a warning to market participants that it may act to prevent manipulation “to help ensure market integrity.”

“The whole market is losing credibility when you have events like this where you try to trigger the CDS or create orphaning situations,” XAIA’s Felsenheimer said.

[siddharth18]

So there's no honor among CDS traders?

[bizaro86]

So, it appears I may not understand these products. (Likely!)

 

A CDS is insurance for a bondholder, correct? So even if an issuer skips a payment if the debt is still good, it would seem to me that the hypothetical bondholder doesn't have any damages.

 

The technical default gives the CDS owners effectively a put on the debt at par, couldn't the CDS sellers just take the debt, pay par for it and then hold it to maturity/refinance?

 

Anyway, I must be missing something, but I'd appreciate being set straight.

[HJ]

So, it appears I may not understand these products. (Likely!)

 

A CDS is insurance for a bondholder, correct? So even if an issuer skips a payment if the debt is still good, it would seem to me that the hypothetical bondholder doesn't have any damages.

 

The technical default gives the CDS owners effectively a put on the debt at par, couldn't the CDS sellers just take the debt, pay par for it and then hold it to maturity/refinance?

 

Anyway, I must be missing something, but I'd appreciate being set straight.

 

That's exactly right.  However, the question then becomes one of how and when are recovery value determined.  There is a wide range of reality between illiquidity and insolvency.  (Think AIG or Fannie Mae / Freddie Mac during the crisis.)  The protection buyers, influenced by their "big short" experience think most default are by definition disorderly, and price recovery value assuming prices are set more by forced sellers at the time recovery value is determined.  However, the very existence of a financier in a distressed scenarios can change the recovery value of a bond or loan dramatically.  The question then becomes can a financier front run his own activity without telling the world about it.  In public securities space, it's insider trading.  These, however, are not public securities.  One can also imagine scenarios where somehow there are more CDS notional created than the underlying financing itself.  Come settlement time, the price setting can be chaotic.  During the crisis, the shorts won, and also wrote the rules as the crisis developed on how to settle these positions.  They claimed big victories, and forced cash settlement on some bonds that subsequently went on to become 10 baggers.  Here, they are getting a dose of their own medicine. 

[HJ]

Follow-up.

https://www.bloombergquint.com/markets/2018/04/11/solus-says-it-may-buy-hovnanian-bonds-to-cut-loss-from-gso-trade

 

Need clear rules for transparent price discovery.

 

The follow-up to the follow-up.

 

https://www.bloomberg.com/view/articles/2018-04-10/hovnanian-s-weird-cds-trade-gets-weirder

 

Whatever you call it, this is not a market. 

[DeepSouth]

So, it appears I may not understand these products. (Likely!)

 

A CDS is insurance for a bondholder, correct? So even if an issuer skips a payment if the debt is still good, it would seem to me that the hypothetical bondholder doesn't have any damages.

 

The technical default gives the CDS owners effectively a put on the debt at par, couldn't the CDS sellers just take the debt, pay par for it and then hold it to maturity/refinance?

 

Anyway, I must be missing something, but I'd appreciate being set straight.

 

CDS settlement is based on the cheapest to deliver bond. So a company can issue a zero coupon long dated bond at a huge discount, default, then the CDS will settle based on the price of that low dollar bond.

[Cigarbutt]

 

A CDS is insurance for a bondholder, correct? So even if an issuer skips a payment if the debt is still good, it would seem to me that the hypothetical bondholder doesn't have any damages.

 

The technical default gives the CDS owners effectively a put on the debt at par, couldn't the CDS sellers just take the debt, pay par for it and then hold it to maturity/refinance?

 

 

Everything is possible as the CDS are based on private OTC contracts but the ISDA has been trying to standardize the process and improve definitions. However, it seems that they have been slow and have difficulty catching up with human ingenuity.

 

With the Big Bang protocol, they have been trying to streamline the procedures. "Physical" delivery of the bond is no longer an option and cash settlement occurs after an auction (potential for biases here, but seems to work reasonably well most of the times).

 

Probably useless thought about financial sophistication:

 

Today, one can immediately transfer significant funds at the touch of a finger. The CDS market is potentially a great idea to hedge (risk management) but parties can transform a relatively simple concept into an endless legal quagmire.

 

I read this AM that, after the 1906 San Francisco earthquake, insurers (mostly British) had to load gold onto ships in London to make port on the Eastern Coast and then transfer the gold to a train that would set out on a multi-day trip to San Francisco.

 

There is one thing that financial innovation has difficulty catching up with: human nature risk.

 

 

[TwoCitiesCapital]

So, it appears I may not understand these products. (Likely!)

 

A CDS is insurance for a bondholder, correct? So even if an issuer skips a payment if the debt is still good, it would seem to me that the hypothetical bondholder doesn't have any damages.

 

The technical default gives the CDS owners effectively a put on the debt at par, couldn't the CDS sellers just take the debt, pay par for it and then hold it to maturity/refinance?

 

Anyway, I must be missing something, but I'd appreciate being set straight.

 

CDS settlement is based on the cheapest to deliver bond. So a company can issue a zero coupon long dated bond at a huge discount, default, then the CDS will settle based on the price of that low dollar bond.

 

I don't think this has been true since physical settlement was done away with in favor of cash settlements. Recovery amounts are based on an auction organized by large banks bidding what they'd be willing to pay for the bonds.

[bizaro86]

So, it appears I may not understand these products. (Likely!)

 

A CDS is insurance for a bondholder, correct? So even if an issuer skips a payment if the debt is still good, it would seem to me that the hypothetical bondholder doesn't have any damages.

 

The technical default gives the CDS owners effectively a put on the debt at par, couldn't the CDS sellers just take the debt, pay par for it and then hold it to maturity/refinance?

 

Anyway, I must be missing something, but I'd appreciate being set straight.

 

CDS settlement is based on the cheapest to deliver bond. So a company can issue a zero coupon long dated bond at a huge discount, default, then the CDS will settle based on the price of that low dollar bond.

 

Thanks! That is the part I was missing. It wouldn't make sense to engineer a default if you couldn't profit from it, but that provides a mechanism.

 

Also provides a bigger incentive for the borrower, since they get funds at a price they otherwise couldn't.