Hovnanian's Weird CDS Trade Gets Weirder
The way bonds work is, I give you $100, and in exchange you give me (say) $6 every year, and then at the end of (say) five years, you give me back the $100. That's if everything goes right. If things go wrong, then after (say) three years, you stop making those $6 payments, and you come to me and say "I know I was supposed to pay you back $100 but here's $40 instead, sorry." This is called "default." The $40 -- an arbitrary number, but traditional in these illustrations -- is called the "recovery."
The way credit default swaps work is, to a first approximation, the same, except that (1) you aren't the company that borrowed the money and (2) they are "unfunded," meaning that I don't put up the $100 in advance. If everything goes right, you pay me $6 a year every year for five years, and at the end of the contract we go our separate ways. (You can think of this as me paying you the $100 at the end, and you paying it back immediately, if you want a tidy parallel to the bond case.) If things go wrong, then after (say) three years you stop making those $6 payments, and now I give you the $100, and you give me back $40. (So, practically, I give you $60, that is, $100 minus the recovery.) It's like you (the "buyer" of the credit default swap) borrowed money from me (the "writer" of the credit default swap), though you didn't. Instead we just made a side bet on some other borrower's bonds.
But the point is that a CDS is a sort of abstract generalized synthetic form of a bond. This has its uses. One well-known use is that it allows people to bet against a company's bonds: Actually short-selling bonds can be difficult, because you have to find and borrow the bonds, but it's easier to just find a bank that will write you a CDS contract and bet against them that way. You don't have to bet against a specific bond, either; the convenience of the CDS is that it is a bet against a company's bonds generally rather than against a specific bond.
Bonds have lots of ways to default. One is just, the company stops paying, and goes bankrupt, and is liquidated, and the bonds get paid off at 40 cents on the dollar in liquidation. Another is, the company stops paying, and goes bankrupt, and continues as a going concern but restructures its bonds so that for every old $100 bond you had you get a new $60 bond. Yet another is, the company stops paying, but stays out of bankruptcy and strikes a voluntary restructuring deal with its creditors where they hand in their old $100 bonds and get back new $80 bonds. These are all possibilities with the bonds, and the CDS market is meant to account for all of those possibilities.
But it's hard! Because CDS is meant to be an abstract generalized synthetic form of a bond, while bonds are so specific. If a company defaults by exchanging its $100 worth of old bonds into $80 worth of new bonds, then bondholders have lost $20, and you'd simplistically expect CDS to pay out $20 (that is, $100 minus the $80 recovery). But actually a lot depends on how the exchange works. The way the CDS contract actually pays out is that I give you $100 and you give me the value of the cheapest-to-deliver bond of the defaulting company. In a bankruptcy liquidation that pretty much mirrors how the bonds pay out, but in a non-bankruptcy restructuring it may not.
So for instance if the company exchanges each old $100 bond into 0.8 new $100-face-amount bonds each worth $100, then bondholders have lost $20, but the new bonds are all worth 100 cents on the dollar and wouldn't create any CDS payoff. This is not usually a real problem because bondholders don't have to do the exchange (and the old, defaulted bonds will be cheapest to deliver), but in Greece's sovereign default, where the bondholders could be forced to exchange, this possibility created some moments of serious worry.
Alternatively, if the company exchanges each old $100 bond into two new $100-face-amount bonds each worth $40, then bondholders have lost $20, but the new bonds are all worth 40 cents on the dollar and will create $60 of CDS payoff. This, too, is not usually a real problem, because companies do not usually deal with the problem of excessive debt by increasing the nominal amount of their debt.
But there's a first time for everything! And now also a second time:
For months now, Blackstone Group LP’s credit unit, GSO, has been trying to profit from a sweetheart debt refinancing it offered an ailing New Jersey homebuilder. The plan calls for Hovnanian Enterprises Inc. to engineer a default that allows GSO to cash in on $333 million of insurance-like derivatives. Unsurprisingly, firms that sold the insurance, including Goldman Sachs Group Inc., protested. One hedge fund even sued, alleging fraud.
Now, in a move that shows just how bizarre this corner of the finance world can get, the homebuilder is asking its creditors to let it refinance yet again -- with new debt so cheap that even blue-chip borrowers would be jealous.
We have talked about the Hovnanian deal several times before. The basic idea is that GSO will give Hovnanian some attractive financing, in exchange for Hovnanian defaulting just enough on its bonds -- failing to make a payment on some bonds that Hovnanian will own itself -- to trigger its CDS. And then the CDS will pay off handsomely because Hovnanian will also issue some bonds with comical terms, specifically a 22-year bond with a 5 percent coupon, which should trade at about 50 cents on the dollar. Hovnanian's regular bonds mostly have coupons like 10 percent and trade at prices like 103 cents on the dollar, so engineering a 50-cents-on-the-dollar recovery on CDS is quite a feat.
But the CDS writers have been trying to block that -- by, basically, bidding up the price of the new ridiculous bonds -- and so Hovnanian is trying to outflank them by issuing a newer and even more ridiculous bond. Here are the press release and Form 8-K for the new bond offer. For every $100 face amount of existing 10 or 10.5 percent four- or six-year bonds, you can get $125 face amount of new 3 percent 29-year bonds. By my casual math those bonds should trade for less than 30 cents on the dollar, giving a package worth maybe 35 cents on the dollar, which seems low given that those existing bonds trade at something like 103 cents on the dollar. This does not seem like a great deal for bondholders. "Such an offering could only be designed for one type of investor: those who, like GSO, have bought insurance against a default," notes Sridhar Natarajan of Bloomberg News. Even for them, I mean, I dunno, you exchange a $103 bond for $35 worth of stuff and get a $70 payout on your CDS; it's not bad, but it's not a giant windfall. Perhaps I am missing something.
But the larger point is that GSO and Hovnanian have figured out a way to break the connection between CDS and bonds. Loosely speaking, with lots of imperfections and nuances and cheapest-to-deliver gamesmanship, the way CDS has mostly worked is that CDS on a company triggers when it defaults on its bonds, and CDS pays out an amount that reflects how much bondholders lost on the bonds. But GSO and Hovnanian have built a CDS trigger in which Hovnanian will default only on bonds that it owes to itself, allowing it to set off a CDS default without missing a payment on any of its "actual" bonds. And they have built a CDS recovery mechanism in which the payoff on Hovnanian's CDS won't have any real connection to the payoff that bondholders receive. You could imagine -- don't try this at home, but you could imagine it -- Hovnanian doing an exchange offer where for every 10-percent four-year bond you hold, you can get (1) a new 10.25-percent 4.5-year bond plus (2) a new 0.25-percent 100-year bond. Bond (2) should be worth very close to zero, giving CDS a recovery of very close to 100 percent, while Bond (1) would be worth close to 100 and bondholders wouldn't suffer any losses at all.
Either of those things might be fine. Breaking the connection between "actual" default and the CDS trigger isn't that big a deal, as I argued when Blackstone did a proto-version of this trade with Codere SA: If a company triggers CDS, it will only pay off to the extent that the company's bonds are actually distressed, which is a more or less fair economic result for a derivative linked to the company's credit. Breaking the connection between bond recovery and CDS payoff also isn't necessarily a big deal: CDS holders expect their payment to be linked to bond recovery, but you could imagine -- and financial engineers have imagined -- a different instrument, an all-or-nothing contract that pays $100 if a company defaults and $0 of it doesn't. That might not be quite as useful as existing CDS contracts, but it's simple, and it would accomplish many of the hedging purposes of CDS.
But both together seem ... bad? Exaggerating slightly, after Hovnanian, a CDS contract looks like a derivative that pays off $100 if the company wants it to, and $0 if it doesn't. That's a weird trade! That gives a lot of power to the company, and ends up feeling pretty arbitrary if you are buying or selling CDS. A derivative with arbitrary payout isn't that attractive; if the CDS market is going to function, it has to have some connection to the bonds.
Everything is securities fraud.
Here is a paper by Daniel Hemel and Dorothy Lund of the University of Chicago Law School on "Sexual Harassment and Corporate Law," in which they "examine the role of corporate and securities law in regulating and remedying workplace sexual misconduct." The basic mechanism should be familiar to Money Stuff readers:
- Company ______s.
- People find out that the company ______s.
- The stock drops as people worry that the company's ______ing will lead to lawsuits or prosecution or lost customers or reduced employee morale or whatever.
- Shareholders sue company for securities fraud, alleging that the company's ______ing was material to shareholders and should have been disclosed.
You can put all sorts of things in the ______: Polluting, selling opioids, selling guns, mispricing chickens, the stuff Facebook Inc. got up to with Cambridge Analytica, really anything that anyone finds unattractive. "Securities law," I wrote recently, "is an all-purpose tool for punishing corporate badness." If you put "tolerating and protecting sexual harassers" in the ______, then you can use that all-purpose tool to go after sexual harassment.
It is also, though, kind of an awkward tool for many of its purposes. "When you punish bad stuff because it is bad for shareholders," I also wrote, "you are making a certain judgment about what sort of stuff is bad and who is entitled to be protected from it." If sexual harassment is treated with securities lawsuits on behalf of shareholders, does that mean that the real victims of sexual harassment -- the real victims of any corporate misbehavior, when you think about it -- are the shareholders? Or as Hemel and Lund put it, in discussing "the potential discursive and distributional implications of using laws designed to protect shareholders as tools to regulate sexual harassment":
Just as the rhetoric surrounding common law actions for seduction and trespass suggested that fathers, husbands, and masters were the ones harmed by sexual assault, shareholder derivative actions arising from sexual harassment might be seen as suggesting that investors—rather than the employees who suffer through sexual harassment firsthand—are the victims whose injuries require redress. Moreover, the claim that workplace-based sexual harassment damages shareholders through the misallocation of human capital might be interpreted to imply that the female employees of publicly traded corporations are themselves corporate assets.
This is not how I would have put it:
The nonbanks turn a profit by charging borrowers a higher rate—say, 15% on a subprime auto loan—than what they pay to the bank, which might be 3%. The bank makes money on that 3% loan because it is funded by deposits, on which it pays almost nothing.
That's from this Wall Street Journal story -- "Big Banks Find a Back Door to Finance Subprime Loans" -- about how banks have gotten out of the business of making subprime consumer loans, but have increased their lending to "nonbank financial firms" which, in turn, make subprime consumer loans. And it's true: The nonbank financial firms make a profit by charging more to lend than they pay to borrow, and the banks do the same.
But that spread, for the nonbanks, is not pure profit. Because, you know, these are subprime loans. Some of them will default. If the nonbank borrows $100 and makes $100 of subprime loans, and only gets paid back $80, it still needs to pay back that $100 loan. So it needs to charge a lot of interest on the $80 that does get paid back, so it can cover the $100 that it borrowed. It also needs to be capitalized to ensure it can pay back its bank loans: Instead of borrowing $100 to make $100 of loans, it will borrow $100 and put up, say, $20 of its own money to make $120 of subprime loans, so that if $20 worth of them default it will still have $100 to pay back to the bank. ("Typically, banks require the nonbanks to commit the loans they make as collateral for the bank loan. And they will only lend the nonbanks an amount equivalent to a portion of the collateral.") The bank, meanwhile, gets paid back its $100 even if the nonbank lender doesn't get fully repaid, so its loans are much safer, so it can charge a lower interest rate than the nonbank lender does. And the bank's depositors are even safer: The bank also has capital, and also gets paid an interest-rate spread, so it can (usually!) pay back the depositors even if the nonbank lender doesn't pay back the bank.
"Still, no loans are risk-free," notes the Journal, a perfectly accurate statement about the essential problem of banking. (If many loans were risk-free, you wouldn't need banks to make them.) But this is a standard story that you see about banking. A company does A Risky Thing. A bank lends the company money to do The Risky Thing. The headline is "Banks Find a Back Door to Do The Risky Thing." But that's not the back door. That's the front door. That's the whole thing banks do. They lend money to people to do risky things. And they take a senior claim: Lending to someone to do the risky thing is less risky than doing the risky thing yourself. When a bank lends money to your local hardware store, that's not the bank getting into the hardware business; that's the bank being in the banking business. (And if the hardware store fails, the bank gets paid back first.) When a bank lends you money to buy a house, that's not the bank moving into your house; that's a mortgage. (And if your house goes down in value, you lose all your equity before the bank loses any of its loan.)
This is the most basic reality of banking, but people are constantly uncomfortable with it. Because it really is discomfiting! "A banking system is a superposition of fraud and genius that interposes itself between investors and entrepreneurs," Steve Randy Waldman once wrote. Banks take in deposits, which they are supposed to keep perfectly safe: Money in a bank account is supposed to be completely equivalent to cash, safe in all circumstances. And then they take that money and they lend it to people running risky businesses doing risky things. They try to minimize those risks -- by making sure that the loans are overcollateralized, by looking the borrower in the eye and concluding that she is trustworthy, whatever -- but "no loans are risk-free." The mystery of banking is that it issues risk-free liabilities in order to finance risky businesses. It is a mystery that constantly renews itself, that is never fully domesticated, that always has the power to make people uncomfortable.
On the other hand it's a little weird that Jefferies, the investment bank, is also in the beef business. Or not quite, but Jefferies and National Beef, a meat processor, are both parts of Leucadia National Corp., a "a highly diversified, but relatively random" company -- in the words of its own executives! -- along with Garcardia, a car-dealership business, and some other, um, random stuff. And now Leucadia is selling down a lot of that random stuff to focus on the financial-services business, and renaming itself Jefferies Financial Group Inc. in honor of that new focus. Jefferies is always described as a "bellwether" for the big banks; it reports its results earlier than the bigger banks do, and so often gives the first hints about how well Wall Street did in a quarter. I suppose you could find something bellwether-y in Leucadia looking at the world in 2018 and deciding to focus exclusively on financial services as its "engine of opportunity."
The Cravath Walk.
Here are some claims about Cravath, Swaine & Moore LLP, the white-shoe law firm:
For those who stay the course to become Cravath partners, it is a lifetime career that comes with a guaranteed annual salary of several million dollars. Underscoring the “lifetime” part are traditions such as the Cravath Walk: every partner is entitled to a procession of past and present partners at their funeral, after which the assembled lawyers chant: “The partner is dead, the firm lives.”
"Entitled"? Would you ... want ... that? You'd be dead, of course, so you wouldn't care, but why would the families allow it? "Next up in the service: Harry's work buddies are gonna chant ominously for a while." It's like John Grisham meets Dan Brown. I hope they wear hooded robes for their chant.
Blockchain blockchain blockchain.
"Yes, These Chickens Are on the Blockchain." No, I will not be taking further questions about the blockchain chickens.
Meanwhile Southern New Hampshire University is blockchaining its blockchain on the blockchain:
“In some ways this is piloting what a modern transcript would be: digital, portable, owned by the student, can be verified using the encrypted assets. Employers ... don’t need to call up SNHU and verify that information, it’s self-verified,” said Colin Van Ostern, the school’s vice-president of Workforce Initiatives, who has been spearheading the project.
Oh sure definitely. You just send a copy of the diploma blockchain to prospective employers, and they look at it and ... come on, come on, they look at this huge file of raw encrypted data and if you are lucky they call up SNHU and say "what the heck is this?" But realistically they just delete it and don't hire you. We talked about this yesterday, the impossibility of solving the problem of trust through technology. The data on the blockchain might be "self-verified" in some vague sense, but not in any practical one: Prospective employers of SNHU graduates aren't going to examine the formal proofs and get into the technical weeds of the diploma blockchain themselves. They're going to rely on some trusted third party to go into the blockchain and make sure that the person has the diploma that she claims to have. Why is that better than relying on SNHU?
People are worried that people aren't worried enough.
I should really change the header of this section, huh? Volatility is back, and people are no longer worried about its absence, which I suppose is good news, though it creates some pressure:
Now that volatility is back and fiercer than it’s been in years, hedge funds can no longer blame calm markets for their woes. A raft of issues -- rising interest rates, potential trade wars, a possible Facebook crackdown -- will likely keep stock prices moving more freely, giving managers ample opportunity to profit on the swings.
“It’s really now or never time,” said Troy Gayeski, senior portfolio manager of SkyBridge Capital, which runs about $6.2 billion and invests in hedge funds. “You’ve got to put up or shut up.”
Whatever you think of this as a theory of markets, I do not think it is a realistic theory of excuse-making. "Hedge funds can no longer blame calm markets for their woes," sure, but they can blame something else for their woes. If you underperformed in 2016 you could blame markets that were artificially calmed by central-bank actions; if you underperform in 2018 you can blame markets that are artificially roiled by trade wars. Or whatever. The point is to try to find some external event that you can argue you shouldn't have expected, and then blame that. There are always going to be external events that you didn't expect, and you can always find some way to describe them that makes your lack of foresight seem sympathetic. In human experience generally, it is unusual for people who do not put up to then shut up.
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