Friday, December 19, 2014

Perversity and Credit Default Swaps

Following up on "It's Time to Regulate Credit Default Swaps Using State Gambling Laws".
There's a reason you are required to have an insurable interest in a person on whom you take out a life insurance policy. Incentives and motives.
From Matt Levine at Bloomberg:
RadioShack Is Running on Credit Derivatives
A good general principle in thinking about derivatives is that real effects tend to ripple out from economic interests. This is not always true, and not always intuitive: If you and I bet on a football game, that probably won't affect the outcome of the game. But most of the time, in financial markets, it is a mistake to think of derivatives as purely zero-sum, two-party bets with no implications for the underlying thing. Those bets don't want to stay in their boxes; they want to leak out and try to make themselves come true.
Here is a Bloomberg News story about RadioShack credit derivatives that I enjoyed. The basic background of RadioShack is:
  • It is in some financial distress, having lost money in each of the last 11 quarters and having recently hired a restructuring consultant as its interim chief financial officer.
  • It is a small company, these days, and it has only $841 million of debt as of November ($325 million of bonds and the rest in three bank loans). Being in distress, those bonds trade at, oh wow, under 20 cents on the dollar.
  • For idiosyncratic reasons, having to do with indexes, there are a lot of credit default swaps outstanding on RadioShack's debt, now about $26 billion gross and $550 million net notional.
So in the near future, RadioShack either will or won't default on its debt, with the market odds implying that it will. If it does default, people who own the debt will lose money; if it doesn't, they'll make money.  Same with the credit default swaps: If RadioShack defaults, and you had previously bought CDS for like 60 points upfront -- paying $6 million for $10 million of CDS notional -- then you make a lot of money. (Like $2.5 to $4 million of profit on your $6 million investment. ) But if RadioShack doesn't default, and you had previously sold credit default swaps for $6 million, then you get to keep the $6 million when your swaps expire.
This creates incentives. Here are the incentives:
  1. If you bought a lot of CDS (long protection/short credit), then  you should try to get RadioShack to default.
  2. If you sold a lot of CDS (short protection/long credit), then you should try to get RadioShack not to default.
Thing 1 is sort of a famous thing, and often thought of as Bad. The idea is that you can buy some of RadioShack's debt (long credit), buy even more CDS (giving you a net short credit position), and then be a meanie with your debt, refusing to negotiate with the company to avoid a default because your incentives are dominated by the CDS position. So instead of being a constructive lender trying to help your borrower survive, you're an evil "empty creditor" trying to burn down the house to collect the insurance, in the more or less officially sanctioned metaphor.

But Thing 1 can also be Good. I mean, there is some debate over the goodness of the Codere trade, but I hope there's none over its beauty. It is objectively beautiful. It even made the "Daily Show." A reminder: GSO Capital Partners (the credit unit of Blackstone) and Canyon Partners owned a bunch of Codere debt, and a bunch of credit default swaps on Codere, a Spanish gaming operator. And they did in fact drive Codere into default so they could get paid out on their swaps, as Thing 1 predicts. But they didn't do it by being meanies with the debt. Quite the reverse: They agreed to refinance Codere's debt on favorable terms, in exchange for Codere agreeing to be two days late on an interest payment to trigger the CDS. GSO and Canyon made money on the CDS, and used some of that money to, in effect, subsidize the loan to Codere to keep it afloat. Everyone wins! Except the CDS sellers. Who lost. How unfair for them....MORE