Two hedge funds made a mess in a corner of the credit market. So guess who’s the cleanup crew? More hedge funds.
Firms including BlueMountain Capital, Citadel, Apollo Global Management, Elliott Management, Anchorage Capital Partners, and CQS have been holed up in Manhattan conference rooms and on calls for months, trying to fix credit-default-swap contracts, people close to the situation say. The talks follow what many see as financial gamesmanship that broke the contracts.
Maligned in the financial crisis, CDS are drawing scrutiny again. Even the Vatican has condemned their use. As banks have pulled back from CDS and trading has contracted, users now skew toward investors seasoned in trading distressed assets, who often lock horns in court fights and exploit legal loopholes, wrangling basis points out of corporate distress and one another. And in a low-yielding world, investors have had to get more creative and use ever-sharper elbows, to generate returns.
In CDS, sellers agree to pay buyers in the event of a default or other trigger. Fans argue that such contracts have legitimate uses, like offsetting risk or guarding against losses, that can help lower corporate financing costs. As interest rates climb and defaults appear poised to rise, CDS are newly relevant for many investors. But CDS have been roiled by a fight between Solus Alternative Asset Management and Blackstone Group’s (ticker: BX) GSO Capital Partners.
Last year, GSO amassed a huge position in CDS tied to the debt of home builder Hovnanian Enterprises (HOV). GSO offered Hovnanian attractive financing on the condition that it skip an interest payment, “triggering” GSO’s CDS and causing it to pay out. How much the contracts pay is set by the cheapest outstanding bond. To control for that, GSO built a cheap bond.
Solus sold CDS, betting that Hovnanian wouldn’t default. But GSO’s carefully engineered trigger and new bond meant Solus was still on the hook for a lot of money.
Solus sued, claiming that GSO’s scheme manipulated the market, and that if GSO got away with it, copycats would follow.
GSO denied any wrongdoing. Still, some of its trades have raised hackles. In 2013, GSO took over a loan to gaming company Codere (CODEF) and pushed it to skip a payment, triggering the CDS. It also helped J. Crew move intellectual property from one debt-issuing unit to another, leaving some lenders with far less value; Eaton Vance and Highland Capital sued. Even within GSO, the creativity of the group spearheading these trades earned it a homemade epithet deriding its use of aggression—complete with a swear.
Blackstone denies the use of the name. “There is no truth to this claim,” spokeswoman Paula Chirhart says. “Our actions were not only compliant with the letter and spirit of the contracts, but also consistent with the expectations of the limited group of sophisticated market participants that are permitted to enter into these contracts.”
Whether such trades are creative or abusive is a matter of perspective. Testing bond indentures, exploiting opportunities, fighting to maximize profit—that’s just investing. Distressed players know there’s not enough value for everyone to get what was promised. Negotiations get intense.
Still, the Hovnanian trade brought scrutiny. The International Swaps and Derivatives Association, which governs the market, said it must rule on a trigger without considering “intent or good faith.” But manufactured triggers “could negatively impact the efficiency, reliability, and fairness” of the market. The Commodity Futures Trading Commission said manufactured events “may constitute market manipulation and may severely damage the integrity of the CDS markets.”
Both statements, while cryptic, didn’t look great for GSO. Behind the scenes, representatives for GSO, Solus, and Hovnanian met with the CFTC and the Securities and Exchange Commission, according to people briefed on the meetings.
The dispute was hurting Blackstone and GSO’s brand. That apparently didn’t sit well with Blackstone CEO Stephen Schwarzman. On May 30, GSO and Solus settled. No CDS were triggered.
Peace hasn’t resolved whether engineered defaults are acceptable. The market has chattered about potential copycats: A fund recently offered McClatchy (MNI) a loan that would “orphan” the unit referenced by the CDS, leaving it tied to a “dead box,” with declining risk.
But that isn’t new. Companies can abruptly decide to issue elsewhere, or pay down debt, or take on more debt.
At a Barclays’ distressed-debt conference in April, a lawyer for ISDA said tweaks won’t fix the problem; it would be like playing Whac-A-Mole, making rules based on what has happened but failing to imagine what could come next. Investors are paid to be creative, to use every lever to generate returns. One loophole gives way to another.
ISDA’s determinations committee, or DC, which rules on these issues, “functions best when there are bright lines,” says the association’s former chief, Bob Pickel. “If there are interpretive issues like intent, market assessment, or whatever, you’re just going to introduce a range of opinions and make it very hard for the DC to function.”
Barclays analysts have analyzed potential fixes. Since Hovnanian skipped a $1.04 million payment to its own unit, they suggest boosting the $1 million threshold to, say, $5 million. Or make nonpayments to affiliates not count. Or scrap “failure to pay” entirely as a trigger in the CDS contract, and stick with “filing for bankruptcy.” Each idea has drawbacks, and all add complexity to a product already struggling to retain liquidity. But without introducing subjectivity in the contract language, it’s improbable that any update can prevent someone from gaming it.
Even so, the almost-consensus of the working group is trying. With the litigation resolved, it can make suggestions without appearing to take a side. People briefed on the conversations say the group will suggest tweaks that introduce just enough subjectivity to close the loophole and prevent these triggers.
Hedge fund Angelo Gordon hired the trade’s engineer from GSO and then hired the Barclays trader who was also on the trade, market participants say.
So this may not be the end of CDS gamesmanship. Maybe that’s the punishment for practicing this vocation: CDS users are damned to endlessly edit contracts and launch updated protocols, an eternal loophole Whac-A-Mole.
