How CDS's are pushing companies into bankruptcy

[geochem1st]

Bloomberg.com: Exclusive

By Caroline Salas and Shannon D. Harrington


March 5 (Bloomberg) -- Amusement-park operator Six Flags Inc. and automaker Ford Motor Co. may be pushed toward bankruptcy by bondholders trying to profit from credit-default swaps that protect against losses on their high-yield debt.

By employing a so-called negative-basis trade, investors could buy Six Flags bonds at 20.5 cents on the dollar and credit- default swaps at 71 cents. If the New York-based chain defaults, the creditors would receive the face value of the debt, minus costs. In a Feb. 27 note, Citigroup Inc.’s high-yield strategists put that profit at 6 percentage points, or $600,000 on a $10 million purchase.

Investors who bet on the collapse of a company are pitting themselves against traditional debt holders at a time when Moody’s Investors Service projects defaults will more than triple this year to the worst level since the Great Depression. The clash may stall restructuring efforts to prevent bankruptcies, as basis traders may be less inclined to participate in distressed debt exchanges, said Matthew Eagan, an investment manager at Boston-based Loomis Sayles & Co., with $7 billion in high-yield assets.

“Before, you really had to worry mostly about where you were in the” company’s capital structure, he said. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.”

Six Flags Debt

Six Flags debt is rated Caa3 by Moody’s and CCC+ by Standard & Poor’s, three and five levels above default. Both rankings were put on “negative outlook” last year. Sandra Daniels, a spokeswoman for the New York-based company, didn’t return a phone call seeking comment.

Ford, the only one of the so-called Big Three U.S. automakers to avoid taking federal bailout funds, may run up against basis traders as it seeks to restructure its debt. The Dearborn, Michigan-based car company plans to offer cash and shares to retire as much as $10.4 billion in debt, according to a U.S. regulatory filing yesterday.

It may be “difficult” for Ford to do an exchange, in part because of investors with basis trades, said Rod Lache, an analyst at Deutsche Bank in New York, commenting last month before the restructuring was announced.

The parent and its Ford Motor Credit finance arm had a net $8.1 billion credit-default swaps outstanding, versus about $54 billion in bonds, according to data compiled by Bloomberg and the Depository Trust & Clearing Corp., which runs a central credit derivatives registry. Bill Collins, spokesman for Ford, didn’t return calls seeking comment.

Profit Either Way

“Say you’ve lent $100 million to a company and you had bought $100 million in credit-default swaps,” said Henry Hu, a law professor at the University of Texas in Austin. “In that circumstance, the creditor really doesn’t care whether or not the company goes under.”

Following a meltdown last year in the relationship between prices on bonds and credit swaps after the Lehman Brothers Holdings Inc. bankruptcy, basis traders often stand to make the most money if companies default. They can also profit by holding the trade until the debt matures or unwinding the position after the market value gap between the bonds and derivatives closes.

Hedge-fund manager Citadel Investment Group LLC in Chicago and Frankfurt-based Deutsche Bank AG were among firms that piled into trades based on the spread between debt and swaps prices. Buying before the Lehman failure and the subsequent seizing up of the corporate bond market, many suffered losses and retreated.

Deutsche Bank Trades

Deutsche Bank was among those who held onto trades, forecasting the gap would close and the losses disappear, according to a person familiar with the lender’s trades.

The German bank made money by owning the debt and credit swaps of Lyondell Chemical Co., a Houston-based oil refiner and chemical producer that went bankrupt in January, the person said.

Lyondell sought and won a 60-day injunction in New York on Feb. 26 against creditors in an attempt to prevent basis traders from going after its Rotterdam-based parent, LyondellBasell Industries AF SCA, and other solvent units, documents filed in U.S. bankruptcy court in Manhattan show.

Bondholders with swaps filed objections to the ban, according to the documents. Jonathan Guy, a lawyer with San Francisco-based Orrick, Herrington & Sutcliffe who represents Deutsche Bank, said in court last month that his client owned Lyondell debt and credit derivatives.

Michele Allison, a spokeswoman in New York for Deutsche Bank, declined to comment, as did Lyondell spokesman David Harpole.

‘Empty Creditors’

“You’re given these control rights under loan agreements or bond indentures on the general assumption that if you’re a creditor, you have an interest in the borrower surviving,” said Hu, who’s written about so-called empty creditors. “Because of things like credit-default swaps, that assumption no longer holds.”

While basis traders may stymie efforts by companies to stay out of bankruptcy, they’re not the corporate bond market’s Darth Vader, the former Jedi Knight in the Star Wars film series who destroyed a planet and sliced off his son’s hand, according to Brian Yelvington, a strategist at CreditSights Inc. in New York. The traders didn’t put the companies into the situation, and derivatives are bringing a measure of efficiency to the market that didn’t exist during earlier recessions, he said.

“You’ve got more information from a side of the market that didn’t exist before,” he said. “People point at CDS causing all of this volatility. To me, it’s always been there. People haven’t been able to place the bets they would have liked.”

Creditor Resistance

For distressed companies such as building materials-maker Louisiana-Pacific Corp., which raised $375 million by selling notes and stock warrants this week, the negative basis also can help generate demand for debt because investors have a cheap way to hedge it, said Bradley Rogoff, a strategist at Barclays Capital in New York.

Residential Capital LLC faced bondholder resistance to a debt-exchange proposal in December, in part because the investors also held derivatives, Rogoff said in a report that month.

With more than $2 billion in credit swaps and about $9.3 billion of bonds at the time, according to Moody’s, the Minneapolis-based company enlisted the support of only 39 percent of its creditors, falling far short of its goal of 75 percent.

During negotiations with creditors, ResCap’s Detroit-based parent, GMAC LLC, threatened creditors to initiate an asset exchange that may have left them with losses on the swaps, according to a written statement released at the time.

GMAC accepted a taxpayer bailout in late December. Beth Coggins, a spokeswoman for GMAC, declined to comment.

$47 Trillion

Credit swaps were created by JPMorgan Chase & Co. more than a decade ago to hedge against losses from bank loans. As dealers made the contracts more standardized, hedge funds, insurance companies and asset managers began using them to speculate on the creditworthiness of companies, sending trading in the swaps up to $47 trillion in 2008, according to the latest data from the New York-based International Swaps and Derivatives Association.

Richard Fuld, Lehman Brothers’ chief executive officer, blamed his firm’s collapse on “destabilizing factors” including credit-derivatives trading in Oct. 6 congressional testimony.

“People are having a hard time trusting anyone,” said Timothy Coleman, co-head of the restructuring group at Blackstone Group LP in New York. “The motivations on the other side of the table are different.”

The combined average price on high-yield bonds and swaps dipped to as low as 85.06 percent of face value on Dec. 8, after Lehman’s failure Sept. 15, according to Barclays Capital. Two weeks before the bankruptcy, the cost was 92.13 percent, and rose to 94.12 percent as of yesterday. Investors who had done trades around the bottom would make as much as 15 percent with a default.

Distressed Debt

Idearc Inc., a Dallas-based publisher of phone directories, may come up against bondholders hedged with credit swaps, said people familiar with basis trading. The company may be forced into a distressed debt exchange or pre-packaged bankruptcy after hiring Merrill Lynch & Co. and Moelis & Co. to advise on its capital structure, Moody’s wrote in a Feb. 9 note.

Credit-default swaps protected a net $1.15 billion of Idearc debt from default as of Feb. 20, according to the Depository Trust. Idearc has $2.85 billion of bonds outstanding.

At the start of November, investors could buy the company’s 8 percent notes due in 2016 at 15.5 percent of face value. They could also purchase credit swaps protecting the bonds from default for seven years for 68 percent of face value, in addition to a 5 percent annual premium.

Gross Payout

The gross payout would be 16.5 percentage points if the company were to default. That gap has since narrowed to 5.75 percentage points, according to data from CMA DataVision and Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

“We intend to look closely at all available opportunities to strengthen our balance sheet and improve our risk profile,” said Andrew Shane, an Idearc spokesman who declined to discuss specific options for the company.

Because the gap between bond prices and swaps converged, many basis traders may have been prompted to exit their positions and take profits. The combined price of Ford’s 7.45 percent notes due in 2031 and five-year credit swaps, for example, has jumped from about 96 percent of face value two months ago to more than 107 percent today, CMA and Trace data show.

‘Resistance’

In 2008, companies got investors to exchange $29.7 billion of bonds in a record 13 trades, according to Edward Altman, a professor at New York University’s Leonard N. Stern School of Business. Altman created the Z-score mathematical formula that measures a company’s bankruptcy risk.

Debt exchanged last year was more than three times the total amount from 1984 through 2007, said Altman. “Firms appear to be scrambling to avoid bankruptcy like never before,” he wrote in his annual report on defaults, published last month.

“Defaults are one of several ways that basis holders can benefit, so it would not surprise me if names with high concentrations of basis holders encounter resistance in their efforts to restructure,” said Michael Anderson, a high-yield debt strategist at Barclays Capital in New York.

 

[SKATTERBRANE]

I am a moron when it comes to finance. On Larry King, Ben Stein keeps on talking about a very simple tool either the FDIC, Treasury or someone, could excersize a simple tool and eleviate much of this mess, and he said they SHOULD have done it last summer. Do you understand or know what he is talking about?

 

[geochem1st]

I am a moron when it comes to finance. On Larry King, Ben Stein keeps on talking about a very simple tool either the FDIC, Treasury or someone, could excersize a simple tool and eleviate much of this mess, and he said they SHOULD have done it last summer. Do you understand or know what he is talking about?

Stein wants to do 2 things:

(1) End mark-to-market accounting requirements, required by FASB.
(2) Negate all the liabilities for credit default swaps as a matter of public policy

Huge moves.

EDIT:
Some clarification. Over-the-counter (OTC) derivatives, like CDS's, are formula-based financial contracts between buyers and sellers, and are not traded on exchanges, so their market prices are not established by any active, regulated market trading. Market values are, therefore, not objectively determined or readily available. Purchasers of derivative contracts are customarily furnished computer programs which compute market values based upon data input from the active markets and the provided formulae. During their early development, OTC derivatives such as interest rate swaps were not marked to market frequently. Deals were monitored on a quarterly or annual basis, when gains or losses would be acknowledged or payments exchanged.

As the practice of marking to market caught on in corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be objectively determined. Since there was no real day-to-day market available or the asset value was derived from other traded commodities, such as crude oil futures, assets were being 'marked to model' in a hypothetical or synthetic manner using estimated valuations derived from financial modeling, and sometimes marked in a manipulative way to achieve spurious valuations.

 

[SKATTERBRANE]

Thanks, what do YOU think about this? Why isn't it being done if it could end all this domino effect? Cut losses and then start over!

 

[SKATTERBRANE]

I am a simpleton. I think a stock should pay a dividend if the company makes money, and NOT pay if a company does not. I do not think speculators should affect anything, and if the speculators are wrong, they certainly should not be protected. Speculation is a risk, and if you lose then you lose, why should others, who do NOT speculate (taxpayers) cover for you. Hell, if someone covered all my bad bets, I would bet willy-nilly on EVERYTHING, collect when I win, and collect when I lose.

Speculators fuck up everything, from the price of a 1970 SS LS6 to a 1959 Les Paul.

 

[geochem1st]

Thanks, what do YOU think about this? Why isn't it being done if it could end all this domino effect? Cut losses and then start over!

I think both those moves should be done. The reason we (The US Govt) now has an 85% stake in AIG is due completely to the CDS mess. The bank bailout monies went to paying off CDS obligations, the money was never used for lending as it would have been if it wasn't for the HUGE hole created by CDS's.

Naked CDS's should be outlawed. They are nothing more than gambling instruments on a tremendous scale, and are used to bet against companies succeeding. They benefit no one but the big players and trash companies and workers.

IMO The Financial Sector, including Wall Street is out of control and needs to be reigned in. Bring back the regulations that were part of Glass-Stegall, and re-evaluate the FED.

 

[SKATTERBRANE]

There should be no futures market or pyramid schemes. The value of a stock should be base on the companies wealth. NOT speculation of what could happen. This causes people to jump on or off bandwagons causing false markets. Buy IBM, sit on it for 30 years, and then sell it. Get a quarterly dividend when they do well, suffer when they do not. As the company goes, so goes the stock holder.

 

[SKATTERBRANE]

I think both those moves should be done. The reason we (The US Govt) now has an 85% stake in AIG is due completely to the CDS mess. The bank bailout monies went to paying off CDS obligations, the money was never used for lending as it would have been if it wasn't for the HUGE hole created by CDS's.

Naked CDS's should be outlawed. They are nothing more than gambling instruments on a tremendous scale, and are used to bet against companies succeeding. They benefit no one but the big players and trash companies and workers.

IMO The Financial Sector, including Wall Street is out of control and needs to be reigned in. Bring back the regulations that were part of Glass-Stegall, and re-evaluate the FED.

If Ben Stein knows this, and you know this, then why do not our political financial leaders know this? Why would these investors have more clout than he companies that are at stake with the politicians? If all human production is raped, then were will the investors gamble?

Why doesn't that bald-headed fuck (I do not remember his name) who warned if we do not pass the first bail-out bill, we will face disaster, well we DID and we still face disaster, understand this? Or was he ONLY interested in paying back the Wall street investors their losses? Are these people SO crooked they would sink a ship just to own it?

 

[SKATTERBRANE]

As usual, people KNOW the answer and what to do, but are unwilling to actually do it. Every last problem that faces people, can be solved, it is a matter of will.

 

[geochem1st]

He who owns the jewels makes the rules...
Money talks BS walks....

Pick one or use a favorite of your own. The people with the bucks pull the strings. Then there are those who believe totally in deregulation of all kinds. Ask Pwozzie.

 

[SKATTERBRANE]

He who owns the jewels makes the rules...
Money talks BS walks....

Pick one or use a favorite of your own. The people with the bucks pull the strings. Then there are those who believe totally in deregulation of all kinds. Ask Pwozzie.

Yes I get the money talks thing, but you would think the corporations that are the REASON for stocks to even exist would trump the traders on Wall street!

 

[SKATTERBRANE]

And Congress should NEVER do anything they do not fully understand. It is better for them to do nothing. I think most of them are no smarter than I am, when it comes to such things.

 

[SKATTERBRANE]

And reporters, and newspeople should not report on things they do not fully understand either. I want only EXPERTS in charge!!!

 

[The_Sentry]

Somewhat related...(and Lord knows we need a bit of humor...)

Heidi is the proprietor of a bar in Berlin . In order to increase sales, she
decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink
now but pay later. She keeps track of the drinks consumed on a ledger (thereby
granting the customers loans).

Word gets around and as a result increasing numbers of customers flood into
Heidi's bar.

Taking advantage of her customers' freedom from immediate payment constraints,
Heidi increases her prices for wine and beer, the most-consumed beverages. Her sales
volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes
these customer debts as valuable future assets and increases Heidi's borrowing limit.

He sees no reason for undue concern since he has the debts of the alcoholics as
collateral.

At the bank's corporate headquarters, expert bankers transform these customer
assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on
markets worldwide. No one really understands what these abbreviations mean and how the
securities are guaranteed. Nevertheless, as their prices continuously climb, the
securities become top-selling items.

One day, although the prices are still climbing, a risk manager (subsequently of
course fired due his negativity) of the bank decides that slowly the time has
come to demand payment of the debts incurred by the drinkers at Heidi's bar.

However they cannot pay back the debts.

Heidi cannot fulfill her loan obligations and claims bankruptcy.

DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better,
stabilizing in price after dropping by 80 %.

The suppliers of Heidi's bar, having granted her generous payment due dates and
having invested in the securities are faced with a new situation. Her wine
supplier claims bankruptcy, her beer supplier is taken over by a competitor.

The bank is saved by the Government following dramatic round-the-clock
consultations by leaders from the governing political parties.

The funds required for this purpose are obtained by a tax levied on the
non-drinkers.
Finally an explanation I understand.

 

[Harpozep]

And reporters, and newspeople should not report on things they do not fully understand either. I want only EXPERTS in charge!!!

I want to live in that world as well. Alas, what we have is more accurately mocked on the Daly Show than reported by Fox and Friends.......

 

[geochem1st]

Somewhat related...(and Lord knows we need a bit of humor...)

You forgot the part about the bankers and insurance companies underwriting and selling securities OTC related to the bars debt, first as a hedge against the bar going under, then over and over again (the same debt), to other banks, hedgefunds, moneymarkets, etc., as bets as to whether the bar goes into bankruptcy or not.

As Heidi files for bankruptcy it triggers the default clauses on all the contracts written, causing a tidal wave of other contracts coming due. The insurance companies don't have the cash to support the contracts that have come due, and the banks that have the contracts, don't have the cash either.... hell they never had them on their ledgers, so the true amount of debt being held was never known.

In an effort to stop a total meltdown of the system a trillion dollars gets authorized to be spent because of Heidi's bar.

 

[SKATTERBRANE]

Somewhat related...(and Lord knows we need a bit of humor...)

Thanks!! And how can this possibly be legal? And how can we fall for this over and over again? Tell me why would this ever be allowed to happen again, and even it it were possible, why would people fall for it again? And the value that dropped 95%, at 5% of its peak value, is still worth MORE than it should be, which is NOTHING. So if you have something that is really worth nothing, but yet still valued at 5% of its former value, then you still have something!!!

Worth and value are not synonymous!

 

[Makeitstop]

Thanks!! And how can this possibly be legal? And how can we fall for this over and over again? Tell me why would this ever be allowed to happen again, and even it it were possible, why would people fall for it again?

That's the payoff of rampant deregulation for you.

- D

 

[05jrock]

Just a pity the whole world has to suffer through all this.

 

[siore]

Somewhat related...(and Lord knows we need a bit of humor...)

Heidi is the proprietor of a bar in Berlin . In order to increase sales, she
decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink
now but pay later. She keeps track of the drinks consumed on a ledger (thereby
granting the customers loans).

Word gets around and as a result increasing numbers of customers flood into
Heidi's bar.

Taking advantage of her customers' freedom from immediate payment constraints,
Heidi increases her prices for wine and beer, the most-consumed beverages. Her sales
volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes
these customer debts as valuable future assets and increases Heidi's borrowing limit.

He sees no reason for undue concern since he has the debts of the alcoholics as
collateral.

At the bank's corporate headquarters, expert bankers transform these customer
assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on
markets worldwide. No one really understands what these abbreviations mean and how the
securities are guaranteed. Nevertheless, as their prices continuously climb, the
securities become top-selling items.

One day, although the prices are still climbing, a risk manager (subsequently of
course fired due his negativity) of the bank decides that slowly the time has
come to demand payment of the debts incurred by the drinkers at Heidi's bar.

However they cannot pay back the debts.

Heidi cannot fulfill her loan obligations and claims bankruptcy.

DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better,
stabilizing in price after dropping by 80 %.

The suppliers of Heidi's bar, having granted her generous payment due dates and
having invested in the securities are faced with a new situation. Her wine
supplier claims bankruptcy, her beer supplier is taken over by a competitor.

The bank is saved by the Government following dramatic round-the-clock
consultations by leaders from the governing political parties.

The funds required for this purpose are obtained by a tax levied on the
non-drinkers.
Finally an explanation I understand

Nice story! Where was this quoted from?

Am I correct to infer from all this, that the alcoholics are at the root of the crisis? And that the solution is to pay up? Where should all the money go? I think that Heidi should get it, but I have a gut feeling that it won't.

Continue the story.