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. 1
- 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. 2 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. 3 (Like $2.5 to $4 million of profit on your $6 million investment. 4 ) 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:
- If you bought a lot of CDS (long protection/short credit), then you should try to get RadioShack to default.
- 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. 5
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.
But of course, they have their own incentives and can do their own thing. That's Thing 2: If you've sold CDS on a company, you should try to make the company not default. And that's exactly what RadioShack's CDS writers did:
“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.”
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.
The CDS writers made a lot of money selling CDS, and get to keep it if RadioShack doesn't default before their CDS expires. So they used some of that money to subsidize a loan to RadioShack to keep it afloat. Everyone wins! Except the CDS buyers. Who lose. How unfair for them.
I mean, it's not that unfair: The CDS buyers bet on a default, and RadioShack has not (yet) defaulted, so they haven't won their bet. But they think they should have won their bet, because this CDS-funded financing looks a little like cheating: The people on the other side of the bet have interfered with the game. So the CDS buyers asked International Swaps and Derivatives Association to declare a default, arguing that the new financing was "structured with a purpose to manipulate the CDS market (i.e., to avoid triggering CDS contracts with a termination date of December 20, 2014)." I don't know exactly what "manipulate" means in that quote, but anyway ISDA declined the request.
Notice the pleasing symmetry between the Codere and RadioShack situations. If you are short a company's credit via CDS, you should want it to default, and one way to do that is to pay it to do a harmless quickie default to trigger your CDS. If you are long the company's credit, you should want it not to default, and one way to do that is to help it get financing to avoid default. Either way, if you have a big enough bet on what the company will do, you should be willing to spend some money to make sure the company does it.
Now, Codere was a lovely trade, and RadioShack is a lovely trade, but the world still awaits the Hegelian synthesis of the two. I want to see a financially distressed company with a lot of CDS outstanding run an auction to decide whether to default or not. CDS writers could offer favorable financing terms to keep the company afloat without a default. CDS buyers could offer even more favorable terms to keep the company afloat with a quick harmless Codere-style default. And then, you know, they keep bidding. They're just giving the company each other's money. Whoever wants it more will offer the best terms.
Even without that synthesis, though, there are some interesting lessons from the RadioShack situation. One is: The Coase Theorem works pretty well in finance, which is I guess exactly where you'd expect it to work. Companies end up defaulting or not depending on who values what outcome more. If there's a lot of money at stake on not defaulting, then some of that money can be used to keep them from defaulting.
But that's a little unsatisfying, because, in the CDS market, there's exactly as much money at stake on RadioShack defaulting as there is on RadioShack not defaulting. Which brings up a related lesson: "Manipulation," whatever it means, is often harder than it first appears, because the people you're manipulating against have their own incentives to manipulate against you. So John Stewart said that GSO's Codere trade "should be illegal," and RadioShack CDS buyers accused the CDS sellers of trying to "manipulate" the market. But, again, the Codere and RadioShack trades are the opposite trades. Perhaps they're both manipulative, sure, why not. But the two sides can manipulate against each other, and in expectation the manipulations and counter-manipulations will cancel each other out and you'll get the economically correct result. 6
One other lesson here goes something like this: Emptiness is in the eye of the beholder. If you think of CDS trading -- especially "naked" CDS trading -- as socially useless financial speculation that doesn't help real companies raise real money for real investments, what do you make of this deal? The CDS writers on RadioShack were long RadioShack credit: They were betting real money in RadioShack's creditworthiness. And, while at first the CDS writers were not as directly invested in RadioShack as its actual lenders were -- they didn't bet on RadioShack by actually giving it money -- they had similar economic interests, and ended up in a similar place, with similar real-world effects. In fact, the CDS writers ended up as lenders to RadioShack. The derivative turned into the real thing.
Bloomberg says that they've had a high of 18.75 and a low of 15.125 today.
Oh, it's more complicated than that; a default would presumably lead to a big restructuring that might actually be better for investors than limping along would be. And everything depends on where they bought the debt, etc. But you know what I mean.
In September, a swaps trader could have sold RadioShack default insurance through Dec. 20 for an upfront payment of $3.65 million on every $10 million of protection. Contracts protecting the same amount through March would have paid $5.3 million, while swaps lasting a year paid about $6 million. As long as the company keeps paying its obligations through the contract’s expiration date, the swaps traders pocket the fees.
I mean, if it defaults, then you get back 100 points, minus whatever the recovery on the bonds is. That is a vexed subject: The bonds are worth less than 20 cents on the dollar now, and would presumably be worth even less in default. On the other hand, there is always the threat of weird CDS auction dynamics when the CDS notional is bigger than the bond notional. But assuming the recovery in default is somewhere between 0 and 15 points, then the CDS payoff will be between 85 and 100, and so if you paid 60 points up front then you make 25-40 points of profit.
I mean, ISDA actually criticizes the analogy:
Recently, a simplistic analogy has surfaced and been repeated that compares CDS to fire insurance. People who use this analogy point to insurance law prohibiting individuals from buying insurance on a neighbor`s house so that they will not burn it down to collect the insurance proceeds. Under this analogy, writing naked CDS is equivalent to buying such insurance and committing arson and should therefore be banned.
The analogy leaves some important points unsaid: How, for example, can buyers of naked CDS actually burn down the house? It is important to remember that for every buyer of CDS there is a corresponding seller who benefits when the reference entity’s credit quality improves. It is unclear how such activity alone can lead to a default by a sovereign government on bonds it has issued.
But John Stewart endorsed it, so.
I mean, in expectation, but not always in practice. Still, this has long been my sneaking suspicion about Libor: A whole lot of banks seem to have fudged their Libor submissions to help their derivatives positions, but there's no reason to think that all their derivatives positions went the same way. So maybe Libor ended up being more or less fine, because the banks who manipulated it up were canceled out by the banks who manipulated it down.
To contact the author on this story:
Matt Levine at firstname.lastname@example.org
To contact the editor on this story:
Tobin Harshaw at email@example.com