Exotic Trades: What CDS Really Are

Credit Default Swaps (CDS) are insurance against the default of a company. These derivative instruments are widely used for hedging and speculative purposes. Over the last few years, some un-orthodox trades have been pulled off. Let's review these transactions, and see what we can learn from them.

A collection of CDS trades

The Codere Trade (2013)

Codere was a distressed Spanish firm. Blackstone's GSO fund bought CDS on Codere, and then went on to offer financing to the firm to keep it afloat, with the condition that it delayed the payment of an interest, hence briefly defaulting and triggering the CDS 12.

The RadioShack Trade (2014)

Radioshack was a troubled retailer, with a lot of debt. It had one specificity, which is that the outstanding amount of CDS was colossal ($26bn gross amount for $840m of debt). The CDS sellers kept the company afloat by renewing short term loans until the maturity date of CDS in december 2014 3. CDS buyers tried to challenge the trade, but ISDA found the trade to be in compliance with the loans and CDS terms 4. The company defaulted soon after.

The Norske Skog Trade (2016)

Norske Skog was a distressed Norwegian firm. Blackstone sold CDS on Norske Skog with a maturity of one year, and provided financing to the firm to keep it from defaulting during that period 5. Norske Skog eventually defaulted a year and a half after the maturity date of the CDS, hence allowing GSO to keep the handsome premiums of the CDS.

The Hovnanian Trade (2017)

Blackstone's GSO bought CDS on Hovnanian, and then offered refinancing to Hovnanian with a similar condition to Codere's: Hovnanian would briefly default on its debt. GSO and Hovnanian structured the refinancing so that it would maximize the payoff on the CDS, by playing with the face value of coupon rate of the new bonds 6. GSO eventually cleared its CDS position with the major counterparties for an undisclosed amount 7.

The McClatchy Trade (2018)

Chatham Asset Management sold CDS on McClatchy, a troubled American firm. It then went on to offer financing with attractive terms to the firm. However, the new debt was assigned and confined to a subsidy of McClatchy, making the CDS on the mother firm worthless, as no more debt supported by the mother firm. Chatham thus went on to collect premiums on the CDS it had sold, without any risks of the instruments being triggered 8.

What you should know about CDS

How do CDS behave: CDS, as well as any derivative instrument, do not behave as you think they theoretically do. They behave just as described in the prospectus and the documentation. The Caveat Emptor applies: if you buy a CDS, you ought to perform the appropriate diligence to ensure that you gain exposure only to the risks you want. After all the trades described above, in which CDS holders were surprised, there are no more excuses.

Why do CDS exist: CDS are hedging tools. Using them for anything else, in particular without a position in the bonds of the firm, is risky. On the other hand, it is quite striking to see that in all of the trades highlighted above, the firm on which the CDS were written benefitted from the transactions: even though all of them were not saved for all time, at least the economic default and the bankruptcy were avoided in the short run.

CDS do not offer free lunch: in each of the trades described above, the party apparently benefiting from the trade did not enjoy a free lunch. GSO, Chatham and others did extensive research and analysis to find suitable targets and ways to structure the deals 9. In addition, they often lent money to the target firms, therefore taking the risk not to be repaid, or to suffer the consequences of a default.

References

Clam Shells are Better Currencies than Cryptocurrencies

Cryptocurrencies, or "digital coins" are terrible at being currencies and do not deserve to bear this name. Clams did much better with no other technology needed than bending over to pick them up from beaches in the XVIIth century. Making the case for clams being better currencies than digital coins hopefully also establishes that today's currencies such as Euro, Dollar, and Yen are much better currencies than digital coins.

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Complexity in Finance: Swing Pricing

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Swing Pricing is a feature which allows some investment funds to adjust their value under specific conditions. The goal is to have investor pay a fairer price, and bear the appropriate charges that their own investment in the fund generates. However, this features comes at a high price: increased complexity.

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Luxembourg, host of many funds using swing pricing

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Revolving Doors: Not The Evil You Think

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First Jose Manuel Barroso, and now Mervyn King: in a few weeks of time, two high-profile politicians have turned to banks: Mr. Barroso joins Goldman Sachs, while Mr. King is heads to Citigroup. Many have criticized the 'revolving doors' and vilified the two former civil servants. But revolving doors are not as evil as is thought.

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Climate Change: The Great Challenge

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COP 21 has been over for about 6 months. Most observers were pretty optimistic back then, and it seemed clear to everyone that action was urgently required to tackle climate change. Some clarity is however still needed now, in order to better understand why economic agents didn’t already take action long ago, without waiting for governments to step up, and thus determine how we can effectively lead our society to improve toward a greener path of development.

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Where To Get Your Daily Shot Of News

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There are plainty of great newsletters and applications out there which allow you to get the essential news of the day. Let's go through this short recommendation list. I didn't rank anything by preference, but rather in the order I receive them on a daily basis.

Morning News

  • The Economist's Espresso (Android, iOS): That's a great app, and typically gives you 5 (very) short articles about news in the world (policitcs, economics, etc.), plus a snapshot with shorter still pieces of information. It's efficient, and you'll receive the morning update in the morning (6:30am)
  • The Market Mogul's Daily Breakfast Briefing: Good timing with this app, which gets to your inbox approximately at 7:30am. Well, hopefully you haven't started your day yet. As for me, it's a perfect additional shot of information that I get when commuting in the morning. It mainly covers economics, and also highlights some good articles published on the website

Midday News

As a European, I have an easy way to get informed during lunch break: the US's morning news. Here are my favorites:

  • CFA Institute's Financial Newsbrief: The first of the midday news trio. It covers a wide range of news, focused on stock-related information and economics news. (12:15am)
  • Bloomberg's Forward Guidance: Bloomberg tells us 5 things we should know about to start the day. Or the afternoon. The myriad of links in this newsletter is very much appreciated (1pm)
  • Seeking Alpha's Wall Street Breakfast: This is a state of the Art daily newsletter, which covers finance and macroeconomics topics, as well as firm's specific news. It is targeted at investors, so the information there is straight forward, and structured so it can easily translate in portfolio management/strategic decisions. (1:15pm)

Editorials

  • Matt Levine's Money Stuff: Matt Levine is an experienced financer. The tone in his brief is decontracted, the focuses are original and different from the previous newsletters. In addition, Matt Levine provides plenty of external links for those who want to know more about the topics he deals with. (3pm)

Specialized News

You may also want, in addition to the above, have some news focused on particular topics. Here are my favorites:

  • PE Hub's Wire: One of the best newsletter out there about Private Equity, Venture Capital, IPO and M&A. The editorial gives the big picture of what's hot in the sector, while the long and exhaustive list of deals allow the reader to dive in more deeply with ease. (1pm)
  • Pitchbook's PE & VC Combined Newsletter: Also focused on PE and VC, this newsletter is issued by a large service provider of the sector. The visuals are terrific - just scroll through this newsletter to immerse yourself in the state of the sector. (4pm)

If you manage to have a look at half this stuff every day, you'll end up being quite up to date about any significant event in the finance world.