There is no reason to own a CDS with a greater notional value than the face value of a debt except for the purpose of gambling. Got that? There is NO OTHER REASON.
From Bloomberg:
RadioShack Kept Alive by $25 Billion of Swaps Side Bets
RadioShack Corp. (RSH) is finding an unlikely ally in its efforts to stay out of bankruptcy: credit derivatives traders who amassed more than $25 billion of trades speculating how much longer it can keep paying its bills.
After a 60 percent surge this year, the amount of credit-default swaps tied to RadioShack is 28 times its debt, more than any other U.S. company. When the retailer’s biggest shareholder arranged $585 million of funding in October to help it survive the holidays, much of the money came from hedge funds wagering on the company to avoid default, said people with knowledge of the trading. Those included DW Investment Management and Saba Capital Management, the people said.
The derivatives are amplifying the stakes on a company with less than $1 billion of debt that’s running out of cash and struggling to compete with online competitors. By injecting the 93-year-old electronics retailer with new money, swaps traders, more often blamed for pushing companies toward bankruptcy, have been preserving big payoffs if they can delay or prevent a default.
“The sellers of the protection built up quite a large war chest, and it took a relatively small amount of money to keep the company going,” said Peter Tchir, a former credit-swaps trader who is now head of macro strategy at Brean Capital LLC in New York. “They have huge incentives to keep the company alive to not trigger the swaps.”
Motivated Lenders
That provided RadioShack’s biggest shareholder, Standard General LP, a potential pool of lenders when it arranged the loans in October. The financing gave the retailer enough cash to stock up for the holiday season while negotiating with other creditors that are blocking a plan to close underperforming stores. RadioShack has struggled to keep up with a migration of sales to the Internet, losing money for 11 straight quarters.
As part of the October funding, DW Investment, run by David Warren, bought more than $100 million of a $275 million first-lien loan, the people with knowledge of the deal said this month. Saba, founded by former Deutsche Bank AG credit-trading head Boaz Weinstein, also bought a piece of the debt, they said. Both firms have swaps investments that would benefit from RadioShack’s solvency, the people said.
Representatives of DW Investment, Saba Capital, Standard General and Fort Worth, Texas-based RadioShack declined to comment.Side bets are a description of what bucket shops do and there are anti-bucket shop laws on the books of just about every state. Federal pre-emption you argue? Nothing a one-line tweak of the Commodity Futures Modernization Act wouldn't solve.
Rare Situation
Among U.S. non-financial companies, only one has more swaps tied to its debt than RadioShack: casino operator Caesars Entertainment Corp., according to the Depository Trust & Clearing Corp. The $28.3 billion of contracts on that company’s biggest unit is 1.5 times its $18.4 billion of obligations....MORE
The ideas are not original to me. Former New York Insurance Superintendent Eric Dinallo said:
“It’s legalized gambling. It was illegal gambling. And we made it legal gambling…with absolutely no regulatory controls. Zero, as far as I can tell,”
A couple of our prior posts:
July 2010
Financial Reform: Enforce New York's 1908 Bucket Shop Law and trash the 2,319 Page Dodd-Frank Bill
It is time to dispense with this congressional foolishness and enforce the 1908 Bucket Shop law.November 2011
Throw in some state anti-gambling statutes and you would have prevented the financial meltdown....
Are Derivatives Contracts Nothing More than Unenforceable Gambling Debts?
...Here's the U.S, Senate testimony of Eric Dinallo, then-Superintendent of the New York State Insurance Department on October 14, 2008 (8 page PDF).
...I have argued that these naked credit default swaps should not be called swaps becausethere is no transfer or swap of risk. Instead, risk is created by the transaction. Indeed, youhave no risk on the outcome of the day’s third race at Belmont until you place a bet onhorse number five to win....
...“Bucket shops” arose in the late nineteenth century. Customers “bought” securities orcommodities on these unauthorized exchanges, but in reality the bucket shop was simplybooking the customer’s order without executing on an exchange. In fact, they weresimply throwing the trade ticket in the bucket, which is where the name comes from, andtearing it up when an opposite trade came in. The bucket shop would agree to take theother side of the customer’s “bet” on the performance of the security or commodity.Bucket shops sometimes survived for a time by balancing their books, but were wipedout by extreme bull or bear markets. When their books failed, the bucketeers simplyclosed up shop and left town, leaving the “investors” holding worthless tickets....
