Reading this made me speechless. One thing is that the same story repeats again (I am only curious if someone is playing against CLO now as "The Big Short" guys did.)
But this...
"They buy a little of the debt of risky companies at a discount, and then buy a much larger amount of insurance on that debt [...]. These wiseguys then do everything they can to force the company into a bankruptcy filing. [...] Since the insurance payment exceeds by far the overall cost of the discounted debt, the hedge fund profits handsomely."
Isn't this insurance fraud? It looks for me like this: I am buying a crappy car, I am somehow able to insure it for a large amount of money (exceeding car value), then I am putting this car on fire and grab insurer money.
The Commodity Futures Trading Commission labeled a similar case as "possible market manipulation", so there definitely is something very fishy going on this type of markets. I'm talking about the "manufactured credit default" of US house-builder Hovnanian. From here [1]:
> A “manufactured default” of a US housebuilder that caused uproar in the credit derivatives market has been called off, after Blackstone-backed hedge fund GSO and Solus Asset Management settled a legal dispute over the trade.
> GSO had agreed to refinance some of housebuilder Hovnanian’s debt at a favourable rate, on the ususual condition that the company miss a payment on some of its bonds. GSO had hoped to profit from credit default swaps that would pay out if Hovnanian defaults.
The Hovnanian deal eventually fell through in later 2018, but only last week did the industry's regulatory body (the International Swaps and Derivatives Association) propose some measures to combat this type of actions.
I think it's interesting. In the case of Hovnanian, you have two companies who are making bets against each other on whether Hovnaian will survive. Hovnanian has no involvement in the CDS market on their own debt. And yet they were able to take the CDS market and turn it into funding, which allowed a company that was in financial trouble to continue to exist and provide jobs.
Solus was free to offer Hovnanian funding with more favorable terms and the agreement to not default. And if GSO and Solus want to go back and forth offering better and better terms then in the end you have a viable company that's leveraged CDS to get additional funding at good terms.
I think a much sketchier case is what Aurelius did to Windstream. There you have no benefit being created on the back of CDS engineering, you just have a hedge fund who drove a viable business into bankruptcy against the wishes of the primary bondholders.
Conceptually, the CDS market is useful. If I do a bunch of business with a company and them going bankrupt would cause me financial problems then I can use CDS to hedge against that possibility. I don't know how you can prevent this kind of engineering though. I think it's easier to prevent what Aurelius did to Windstream. But the GSO/Hovnanian deal seems much harder to regulate.
Maybe instead we just decide that it was actually a good thing and going forward people should be aware that it's a possible outcome? The risk of default isn't just the risk that the company on its own defaults, but also the risk that the company defaults and can't find outside funding. If people are expecting that eventuality then the CDS market should settle in a spot that prices in the possibility of CDS buyers or sellers offering refinancing.
These shenanigans provide a real economic benefit to companies at the risk of long-term damage to an established market. High yield and distressed CDS is more or less a joke right now because of this stuff and the only thing restricting this from higher quality names is no one is big enough to play games at that scale. Without a credible market, the "financing opportunities" for companies will disappear.
In an already inefficient market, it's also very hard to price the possibility/structure of these games as it's not like the company can publicly shop around deals for this. In the case of the HOV deal, issuing new bonds to game CDS deliverables was unprecedented and IMO just total nonsense.
> I am only curious if someone is playing against CLO now as "The Big Short" guys did
Absolutely they are. The heroes of The Big Short weren't doing anything particularly unusual or special. They were just using credit instruments to bet that they'd be more foreclosures than the market was predicting. There'll be equivalent hedgies doing the same with corporate debt now.
> Isn't this insurance fraud?
No because it's not actually insurance as others have said. They're using similar credit instruments to bet against corporates that the Big Short folk used to bet against mortgages.
Is what they're doing ethical? Probably not though you have to be careful. If you look at the Windstream example linked in the article, I'd argue that the hedgie is using ethically questionable methods to expose, and take advantage of, ethically questionable corporate practice. Not entirely clear who the villain is with that one. Probably both parties.
The article treats the Windstream example like a smoking gun for market manipulation but the cited evidence is a little softer than he's suggesting. All the link really provides is Windstream's claim that Aurelius forced them into bankruptcy, which the judge evidently didn't find to be compelling. Windstream proposed a recovery plan for any default caused by the Uniti spinoff and Aurelius didn't agree to the plan. That doesn't prove that Aurelius shoved Windstream in front of a train, only that they didn't pull them off the tracks.
It's not insurance fraud (or fraud of any kind). Fraud is theft by deception. Your car fire example is fraud because to get the payout you have to lie to the insurance company about why the car caught on fire. Car insurance contracts quite explicitly exclude coverage for intentional damage, so if you tell them you set it on fire on purpose, they won't pay you.
In this instance, the "insurance" is actually a credit default swap (CDS). CDS contracts do not exclude "coverage" in cases where the "insured" provokes the company into default. There's no need for deception to make the scheme work, meaning it's not fraud.
The CDS contracts are put together by an industry association called ISDA, with a lot of input from very sophisticated market participants and their very expensive lawyers. It was most likely a conscious decision to make the contract work that way. Anybody who got burned by this directly either knew it was possible or should have known it.
For car insurance you need to buy a car. For debt insurance, not really. I think the editor meant "debt options" but used the word insurance because he was targeting a non-sophisticated audience.
Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy?
> Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy?
Well, right now, "somebody" is selling long dated OTM put options on some ETF's that are filled with +95% junk rated bonds and/or CLO's, with some of the strikes having +100k OI for pennies on the dollar (ex. HYG60P12202019), which in normal times might be easy money from selling… I'm sure the big boys have better ways of getting exposure as well.
Even though a CDS contract has the look and feel of insurance, it is carefully written to not be insurance legally, which would attract an additional regulatory burden (only regulated insurance companies can sell insurance, pretty much any financial market participant can sell credit protection against some debt).
But this...
"They buy a little of the debt of risky companies at a discount, and then buy a much larger amount of insurance on that debt [...]. These wiseguys then do everything they can to force the company into a bankruptcy filing. [...] Since the insurance payment exceeds by far the overall cost of the discounted debt, the hedge fund profits handsomely."
Isn't this insurance fraud? It looks for me like this: I am buying a crappy car, I am somehow able to insure it for a large amount of money (exceeding car value), then I am putting this car on fire and grab insurer money.