A good general principle in thinking about derivatives is that real effects tend to ripple out from economic interests.This is notalways true, and not always intuitive: If you and I bet on a football game,that probably wont affect the outcome of the game. But most of the time, in financial markets, it is a mistake to thinkof derivatives as purely zero-sum, two-party bets with no implications for the underlying thing. Those bets dont want to stay in their boxes; they wantto leak out and try tomake themselves come true.
Here is a Bloomberg News story about RadioShack credit derivatives that I enjoyed. The basicbackgroundof 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 20cents on the dollar.
- For idiosyncratic reasons, having to do with indexes, there are a lot of credit default swaps outstanding on RadioShacks debt, now about$26 billion gross and $550 million net notional.
So in the near future, RadioShack either will or wont default on its debt, with the market odds implying that it will. If it does default, people who ownthe debt will lose money; if it doesnt, theyll make money.Same with the credit default swaps: If RadioShack defaults, and you had previously bought CDSfor like 60points upfront — paying $6 million for $10 million of CDS notional– then you make a lot of money. (Like $2.5 to $4 million of profit on your $6 million investment.) But if RadioShack doesnt default, and you had previouslysoldcredit default swaps for $6 million, then you get to keepthe $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 getRadioShack to default.
- If you sold a lot of CDS (short protection/long credit), then you should try to getRadioShack 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 RadioShacks debt (long credit), buy even more CDS (givingyou 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, youre an evil emptycreditor trying to burn down the house to collect the insurance, in the more or less officially sanctioned metaphor.
But Thing 1 can also be Good. I mean, there is some debate over the goodness of the Codere trade, but I hope theres 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 driveCodere into default so they could get paid out on their swaps, as Thing 1 predicts. But they didnt do itby being meanies with the debt. Quite the reverse: They agreed to refinance Coderes 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 moneyon 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. Thats Thing 2: If youve sold CDS on a company, you should try to make the company not default. And thats exactly what RadioShacks 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 doesnt 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,its not that unfair: The CDS buyers bet on a default, and RadioShack has not (yet) defaulted, so they havent won their bet. But they think theyshould havewon their bet, because this CDS-funded financinglooks a little like cheating: The people on the other side of the bet have interfered with the game. So the CDS buyersasked International Swaps and Derivatives Association to declare a default, arguing that the new financing was structured with apurpose to manipulate the CDS market (ie, to avoid triggering CDS contracts with a termination date ofDecember 20, 2014). I dont 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 companys 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 companys 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 enoughbet 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 outstandingrun an auction todecide whether to default or not. CDS writers could offer favorable financingterms to keep the company afloat without a default. CDS buyers couldoffer even more favorable terms to keep the company afloat with a quick harmless Codere-style default. And then, you know, theykeep bidding. Theyre just giving the company each others money. Whoever wants it more will offer the best terms.
Evenwithout 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 youd expect it to work. Companies end up defaulting or not depending on who values what outcome more. If theres a lot of money at stake on not defaulting, then some of thatmoney can beused to keep them from defaulting.
But thats a little unsatisfying, because, in the CDS market,theres exactly as much money at stake on RadioShackdefaulting as there is on RadioShack not defaulting. Which brings up arelatedlesson: Manipulation, whatever it means, is often harder thanit first appears, because the people youre manipulating against have their own incentives to manipulate against you. So John Stewart said that GSOs Codere trade should be illegal, and RadioShack CDS buyers accusedthe CDS sellers of trying to manipulate the market. But, again, the Codere and RadioShack trades arethe opposite trades. Perhaps theyre both manipulative, sure, why not. But the two sides can manipulate against each other, andin expectation the manipulations and counter-manipulations will cancel each other out and youll get the economically correct result.
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 doesnthelp 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 bettingreal money in RadioShacks creditworthiness. And, while at first the CDS writers were not as directly invested in RadioShack as its actual lenders were — they didnt 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.
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