** UPDATE **
The CEO of Solus was on Bloomberg this morning explaining the situation. Great video if the blog below is a bit too arcane to read through.
“Bloomberg – The Great Blackstone Swaps Saga Just Became a Whole Lot Crazier“
Buckle up. This is a doozy, but it’s also one of the more ridiculous stories from the street in the last few years. It’s also a great example of what I alluded to in my very first post, where I opined that financial services has almost completed its transformation into a parody of itself. This may be the story that pushes it over the proverbial goal line.
Credit-default swaps (“CDS”) were invented in the early 90’s by Blythe Masters and her team at J.P. Morgan in response to the Exxon Valdez incident. JPM extended $5B in credit to Exxon for remediation costs after the spill and wanted to hedge the credit risk associated with it. For the uninitiated, investors buy CDS to hedge their long exposure to a company’s bonds, or, in the case below, short the company’s bonds outright and make money if they default. It’s simply an insurance policy against a company defaulting on their obligations.
The CDS market is governed by the International Swaps and Derivatives Association (“ISDA”), which is a self-regulatory committee that has developed the framework for what constitutes a technical default in the CDS market. There are many nuances and mechanisms in the framework that make determining whether or not a credit event has occurred more difficult than it should be (we saw this in the Greek sovereign debt debacle of 2012, which was eventually ruled a default after much debate). I don’t want to get into the weeds too much, but there is one mechanism we do have to touch on – that is “cheapest-to-deliver”.
The idea behind CDS is that they protect investors from default generally, not specifically. Meaning, it doesn’t matter which of a company’s bonds actually trigger the default. Once the ISDA committee determines a credit event has occurred, the company is now “in default” and CDS will pay out across the capital structure (equity not included, of course) in what they call a credit auction. The auction consists mainly of banks and investors determining at what prices they would be willing to buy and sell the defaulted bonds, which then sets the recovery and payout amounts. Once the trades clear and a recovery price is determined, the CDS will payout via a cash settlement. The payout will be equal to (1 – recovery %) * CDS notional amount. This is where cheapest-to-deliver comes in. If you are short bonds through CDS, you need to deliver bonds to the bank to settle the trade. Remember, we said CDS protects investors generally and not specifically, meaning if you need to deliver bonds for settlement, all you need to do is go out and source the cheapest one possible for delivery to the bank. For example: If I’m short a company’s bonds, I don’t actually own a particular bond to hedge. I’m purely gambling that they’ll default one day – so when they do, I just need to go out and find the cheapest company bond possible for delivery to maximize the payout. If you have the option to deliver a $20 or $30 bond on a $100 CDS, you deliver the $20 bond every time and take the $80 payout (this is oversimplified for purposes of the blog).
K, now that we have that out of the way we can get into the actual story. A couple of years ago, Blackstone (through their credit entity, GSO) put on a large CDS position against a New Jersey-based homebuilder, Hovnanian. They were betting that the company would default on its debt, triggering the CDS to payout and padding some MD’s pockets. Well, the thing is, that never actually happened and Blackstone decided they were going to do what it took to force a default. They offered to structure a refinance package which would have Hovnanian exchange their current bonds for newly issued ones at longer maturities, lower rates and, hilariously, a higher notional amount of debt on their books (while technically the incremental debt wouldn’t hurt them since the rates are so low and maturity so long, its funny to hear of a company solving their debt problems by adding more debt to its balance sheet). This means that the company says “Hey, we know you had $100 bond from us, but we’re gonna replace that with a new bond that says we owe you $125 now. Oh, and it’ll also be at a much lower rate and take us much longer to pay you back.” That crushes the value of the new bonds in the market, which would work precisely in Blackstone’s favor if the company defaulted and Blackstone was forced to deliver the bonds for settlement in the auction under the “cheapest-to-deliver” mechanism. The only thing left was figuring out how to structure the default. Well, the parties decided that a Hovnanian affiliate would buy back some of the old bonds before the exchange, and there would be a clause in the new bonds that prohibits the Hovnanian (and its affiliates) from making any interest payments on the old bonds prior to maturity, triggering a default – through a subset of bonds that only Hovnanian itself owns! For the avoidance of doubt, Hovnanian was going to halt interest payments it owed to itself in order to trigger the default. That’s just shameless.
Naturally, the banks and hedge funds that were on the hook for CDS payouts were less than excited about this newest feat of financial engineering. One fund, Solus Alternative Asset Management, is taking their grievances to the courts, which is fine (but arduous). However, there’s always been one firm that’s never been afraid to go to the mattresses, who wasn’t going to take this disrespect lightly. One firm who wields so much power in the markets that anyone would be crazy to cross them: Goldman Sachs. Goldman was one of the largest sellers of Hovnanian CDS, and they stand to lose a hefty amount if Blackstone pulls this off. They had been relatively quiet on the matter, until some chatter started popping up last week that Goldman, alongside Solus and Anchorage Capital, had been lining up enough demand for the defaulted bonds in the upcoming credit auction that they would be able to push the price up high enough to materially impact the recovery amount and wipe out most of Blackstone’s potential CDS payout – which makes sense! There should be demand for this company’s debt, they’re in an even better financial position in default than they were beforehand thanks to the refinance package. The value of Hovnanian CDS dropped sharply on the rumors and it appeared that Blackstone had met their match. That’s a veteran move by a market-maker that knows exactly what they’re doing – kudos to GS.
BUT… if you thought that was the end of it, you don’t know how petty money can make people. Hovnanian has now announced it’ll be exchanging an additional $840M worth of bonds at, once again, a higher notional amount, with a 3% coupon and a maturity date of 2047. That, my friends, is the most preposterous thing I have ever seen in my life. That’s almost exactly on par with what it costs the U.S. government to borrow money for thirty years, and these guys just build houses for a living. As you can expect, this will depress Hovnanian bond prices further should they decide to move forward with this newest exchange, once again putting Blackstone in a perfect place to cash in on their CDS position in the upcoming auction. As a result, their position has materially increased in value over the last couple of days.
Truth be told, this is a sad day. Blackstone is making a mockery of, if used properly, a great market mechanism to manage the risk associated with financing growing companies around the world. The CDS market suffered greatly in the post-crisis era of tighter regulations, but this will likely be the straw that breaks the camel’s back. The ability for a company itself to determine if and when it will trigger an unnecessary technical default makes the instruments utterly useless and, if that’s the case, then maybe the CDS should die because Pandora’s Box is now open. Markets do need a way to hedge credit risk, though. There just isn’t a clear alternative in the works yet. In my opinion, the easiest mechanism would be for re/insurers to be paid a nice fee to wrap each individual bond issuance with market standard triggers (just like their regular insurance policies), but that is probably unlikely after what AIG, MBIA and AMBAC did to themselves in the financial crisis. If anyone has any ideas, I’d love to hear them.
