CDS Buy-Side Hedgers, Arise

Includes: BX, HOV
by: Kurt Dew

Credit default swap (CDS) hedgers wait for someone to repair this broken market.

Multiple market brouhahas have brought the CDS market into disrepute.

If hedgers don’t act, the CDS market will wither away.

CDS contracts promise, for a fee, to pay the buyer for damages in the event of a “default” on a debt issue specified by the CDS. There is universal agreement among fixed income traders and market regulators that the CDS market needs reform.

By any standard, this market has failed to meet its original objective – to provide a routine hedge for risk manager’s credit exposure to specific debts. But these hedgers, insurance companies, investment houses, and pension funds – the buy-side, expect other market participants less affected by the ailing CDS market fix it. Only regulators and sell-side associations have lifted a finger to rescue CDS. The risk managers of the buy-side sit on their hands.

However, if the CDS market is ever to be fixed, it will only be through the efforts of the direct beneficiaries of a properly functioning CDS market.

In other words, if CDS hedgers wait, nothing will change. Other market participants serve up superficialities; regulators quibble. And why not? These market participants have little to gain. And nothing that has happened to date violates regulations.

Debt issuers are the root source of CDS market problems, not hedge funds.

While much reform has been proposed, and changes are in the works, none of these reforms focus on the root source of CDS market problems. The root problem of the CDS is the built-in legal incentive of debt issuers to profit from CDS market manipulation. Hedge funds seduce issuers of the debt underlying a CDS. Positions that may be manipulated to benefit issuers are bought and sold, then issuing firms modify the conditions of the underlying debt issue, sharing the profit from CDS positions held by their coconspirators, expecting a reward for their efforts.

This is an uncomfortable fact, since market regulators have feigned, or have, no awareness of debt issuers’ complicity. Moreover, the complicity of debt issuers in the CDS market has not been examined by market regulators. And of course, regulatory censures of hedge funds are more popular politically than the censure of corporate issuers.

What a terrific con! Issuers are like maidens that conspire with the villainized hedge funds that supposedly threaten issuer safety, waiting for the inevitable rescue and splitting the resulting gains. And it's all IMO legal.

Issuers have never, until recently, shown any interest in CDS. But without an issuer that benefits by manipulating CDS, most CDS schemes are not viable.

Most of the flaps in the CDS market of late have been traced to the activities of hedge funds, but a glance at the specific claims of debt market manipulation resulting from CDS market activities reveals that hedge funds colluded with issuers to profit from their shenanigans.

The state of the CDS market.

The issuers of corporate debt have no loyalty, no legal or ethical responsibility, to risk managers participating in the debt market. Indeed, issuers’ legal and moral obligation to their stockholders often conflicts with the interests of corporate debtholders, ultimately resulting in the ruin of the CDS market.

Neither the CDS market nor the debt market itself can be protected from an engineered CDS default. At least, that’s how the matter stands today. The market needs an extralegal rule-maker with debtholder interests at heart.

The CDS market is conspicuous for the rapid decline in both transactions and amount of CDS outstanding, as the chart below, from The Bank for International Settlements (BIS) describes.

The remedies that have been proposed to date are of dubious merit, or so say unnamed industry regulators, as reported in a Bloomberg August 5th article. However, this regulatory concern is not due to a lack of sell-side cooperation with regulators' intent. The International Swap and Derivatives Association (ISDA) has developed a proposed set of changes to “The 2014 ISDA Credit Derivatives Definitions Relating to Narrowly Tailored Credit Events,” the document that more carefully describes circumstances in which default occurs.

Nonetheless, events of default are sufficiently ambiguous that it is necessary to form a panel to decide whether a default has occurred. The opinion of the bankruptcy courts is insufficient to decide. In the words of Claire Boston, writing for Bloomberg,

“In practical terms, a ‘credit event’ is default if the 15-member Credit Derivatives Determinations Committee made up of some of the market’s biggest players determines it is, in which case the swaps will pay out after a price-setting auction.”

In summary, the meaning of default is inherently ambiguous, and the ways of “manufacturing” a default, by a hedge fund in cahoots with the issuer of the underlying debt, innumerable. Without a proactive examination of trader positions by a neutral third party with rule-making authority, the CDS market cannot function as intended.

The CDS problem has not been resolved.

That a risk manager should consider a CDS for routine protection from default on a plain vanilla bond or loan – the reason the CDS was invented – has plainly become a dubious proposition.

There have been numerous complaints, alleging that one side of a specific CDS transaction has interfered in the expected payments of the underlying insured debt. The complaint usually alleges that a hedge fund has taken advantage of special situations created by the terms of a specific CDS-insured debt issue, changing default probability on the underlying debt in order to profit from the increasing value of the hedge fund’s side of the swap.

Several highly publicized incidents in the CDS market have drawn national attention to this market. The classic example is a CDS written to protect a debt issue of Hovnanian (HOV), a large construction firm. The Hovnanian donnybrook was engineered by GSO Capital, a subsidiary of the huge Blackstone Group LP (BX), which conspired with HOV to create a payday for GSO on a CDS GSO had bought, covering a specific HOV debt issue.

In a series of articles, here, here, and here, I show the required need for either issuer complicity with a CDS scheme, or in some cases issuer negligence, in order for a hedge fund to take advantage of the other side of the CDS.

In the third article listed above, I bring attention to the fact that no hedge fund is needed for a corporation to choose to benefit its stockholders at the expense of its debtholders through use of CDS written on the corporate debt. In fact, the case can be made that in the presence of a CDS market that can be traded by the firm itself, no other path other than the use of CDS to benefit the stockholder at debtholder’s expense is consistent with corporate management’s legal obligation to its stockholders.

Why the status quo won’t work.

The regulators of the CDS market have set industry participants an impossible task.

In the words of John Williams, here

“If regulators want to improve the market -- and I applaud their efforts -- I would really encourage them to share their specific concerns, including concrete examples of transactions they see as potentially harmful to the markets, so we can roll up our sleeves and get to work together,”

Regulator specifics have not, and will not, be forthcoming.

In response to questions from authors of the Bloomberg article cited above, the SEC released a statement, “SEC staff welcomes continued engagement with market participants on these matters.” And the CFTC commented that current market events raise “critical questions of whether there is market manipulation, and we are looking very closely at it.” What a load of you know what.

What will work?

The CDS dilemma is best understood as a special case of the basic debt dilemma. This broader perspective reveals the root source of accumulated failures of efforts to repair the CDS market to date.

The naked truth is that the debt market itself is out of balance. Without a balance of buyer’s rights with those of issuers and other market participants, CDS traders will always be vulnerable to legal issuer manipulation of the value of debt underlying CDS.

Debt market government regulators – the CFTC, the SEC and the Fed – and market self-governing associations – the ISDA, FINRA, and the exchanges – focus on the protection of two of the three centers of debt market participation – participants in transactions and issuers.

Risk managers of the buy-side have nobody in their corner but themselves. If there is genuine risk manager interest in a viable CDS market – or for that matter a liquid debt market – it is up to the buy-side to act. The buy-side should find a representative of its interest in a marketplace the buy-side regulates. My cynical colleagues have laughed this proposed buy-side initiative off. But I live in hope.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.