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.
- "Blackstone Made Money on Credit-Default Swaps With This One Weird Trick", Matt Levine, Bloomberg
- "The truth about Blackstone and Codere", Felix Salmon, Reuters
- "RadioShack is Running on Credit Derivatives", Matt Levine, Bloomberg
- "CDS Allegations Surround RadioShack", Mike Kentz, Reuters
- "GSO's Win-Win on Norske Skog CDS", David Wigan, Robert Smith, IFR
- "Hovnanian misses bond payment in controversial ‘manufactured default’", Joe Rennison, Financial Times
- GSO settled with Goldman Sachs and Solus
- "Hedge Fund Gambit Stirs Fresh Controversy in Besieged CDS Market", Sridhar Natarajan, Bloomberg
- "The mystery trader who roiled Wall Street", Miles Johnson and Robert Smith, Financial Times