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Matt Levine

Sears Default Bets Pay Off for Sears

Also tokenized real estate, sponsored research, IPO-vs.-sale and Elasmotherium sibiricum.

Sears Holdings Corp. is a retailer that recently went bankrupt. Cyrus Capital Partners is a hedge fund that has been widely reported to have sold a lot of credit default swaps that would pay out if Sears defaulted on its debt. Sears defaulted on its debt. So the CDS will pay out. But the CDS that Cyrus apparently sold does not actually reference Sears Holdings, which has a lot of debt (that it defaulted on). It references Sears Roebuck Acceptance Corp., a subsidiary that Sears used to use to issue a lot of debt, but now doesn’t. SRAC has some defaulted debt, but not that much; in particular, there is more SRAC CDS than there is actual SRAC debt.

This creates a weird dynamic, because CDS payouts are based, roughly, on an auction of the reference debt held after the default: $100 of CDS will pay out $100 minus the auction price of $100 face amount of bonds. Normally, you hold an auction, and people bid for the reference debt based on how much they think it will recover in bankruptcy, and CDS then pays out the difference between par and that recovery value. But with lots of CDS and not much debt, the auction can be swamped by gamesmanship: The people who sold the CDS will overpay for the debt in the auction, because that way they can underpay on their CDS. (If there’s $100 of debt and $200 of CDS, every extra dollar that you pay for the debt reduces by $2 your payout on the CDS.)