How a Twist on Credit Derivatives Warps the Market: QuickTake

Credit-default swaps are stirring controversy in markets again, a decade after they played a key role in the 2008 financial crisis. These contracts, known as CDS, are a type of insurance against a company or country defaulting. Now some hedge funds, as part of financing packages they extend to troubled companies, are pressing the companies to trigger or avert payouts on these derivatives, depending on what side of the trade the hedge funds are on. To critics, using CDS trades this way amounts to rigging an $11 trillion market.

Here’s an example. Last year, Blackstone Group’s GSO Capital Partners extended financing to homebuilder Hovnanian Enterprises Inc. that included an unusual condition: Hovnanian had to miss an interest payment on a portion of its debt, a default that would trigger payouts on Hovnanian credit derivatives. This would provide a windfall for GSO, which had bought the derivatives beforehand and would use the payouts to subsidize the relatively cheap financing it was offering to the builder -- an apparent win-win. But Solus Alternative Asset Management was on the other side of credit-default swaps linked to Hovnanian, and was therefore in line to lose. It cried foul and sued. At the end of May, the two hedge funds announced a settlement under which Hovnanian made a payment it had missed, avoiding triggering the derivatives.