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Too Big to Ignore

Debt derivatives markets are encroaching on corporate finance decisions.
Jason Karaian, CFO Europe Magazine
September 26, 2007

No market worth nearly $30 trillion can be easily ignored. But until recently that's what most CFOs did when it came to credit-default swaps. And not without good reason. Default-swap investors make bets on a company's creditworthiness without necessarily owning the underlying bonds, and with no legal claim on corporate assets, why should CFOs care about the derivative traders' concerns?

"Put simply, derivatives trading is nothing but gambling," says Richard Nevins, a London-based corporate lawyer specialising in complex transactions at Cadwalader, Wickersham & Taft (CWT). "CFOs may find it somewhat distasteful to take this marketplace into account because, let's face it, it's the world's biggest casino."

After doubling in size annually for over a decade, the default-swap market is now ten times the size of the corporate bond market. Whereas once bondholders bought default swaps as protection against default, investors these days purchase corporate debt to protect default-swap positions. Not surprisingly, more than 60% of trading is now accounted for by hedge funds, according to consultancy Greenwich Associates.

Some default-swap bets are so large that investors "manipulate the bond market as a result," according to Robert McAdie, head of global credit strategy at Barclays Capital in London. And when the wishes of derivatives investors clash with the priorities of corporate borrowers, CFOs can't help but take notice.

Some recent examples show how the booming debt derivatives markets are encroaching on corporate decision-making.

Avis: Protection Money
Last year, Avis Budget Group became the sole legal corporate descendent of Cendant, after the American conglomerate split into four companies. As a result, the default swaps written on Cendant's debt were worthless. However, by convincing Avis to issue an essentially meaningless parent-company guarantee on bonds issued by its main subsidiary, Cendant default-swap investors reactivated their contracts.

To that end, a group of default-swap investors paid $14m to Avis Budget Group in February to guarantee the bonds of its subsidiary, Avis Budget Car Rental — a strange move, given that the parent company's credit rating was lower than its subsidiary. "Any additional asset protection that the parent could offer at the current moment is minuscule at best," wrote analysts from CreditSights at the time. A multi-million dollar return for a minor legal tweak was certainly a shrewd move by David Wyshner, CFO of Avis.

"We can truly say that this 'consent fee' wasn't expected and reminds us that the mechanics of the credit-default swap market remain open to new strategies in the absence of more definitive rules and regulations," noted the CreditSights analysts.

"The economics must have been hideous to push the investors to pony up cash and, in essence, bribe the company to achieve a certain outcome," notes Nevins of CWT.

Experian: Stepping Up
In another corporate break-up last year, Experian, which produces personal credit reports, inherited its parent's debt when U.K. retail group GUS split itself up. Experian soon found itself a buyout candidate, spooking bondholders. To allay their fears, Experian offered a change-of-control clause, which included a small consent fee and the option to redeem bonds at par. To the company's surprise, holders of its 2013 bond rejected the change in terms. Several hedge funds with large default-swap positions had bought the bonds in order to resist a tender, which would "orphan" their derivatives contracts.

At first, Experian took a hard line. The company "will not be held to ransom," director of finance Peter Blythe said last September. After two months of negotiations, however, the two sides settled. In the event of an LBO, bondholders could either redeem at par or accept a 200 basis point "step up" in coupon payments, ensuring the existence of underlying debt for default-swap investors.

Cairn Capital, a hedge fund, hailed Experian's step-up clause as an "important innovation" which should be adopted more widely. "The way the bondholder group and Experian have worked together to reach an agreement should serve as a model for future situations, of which there will undoubtedly be many," Cairn said.

Although it could be considered a poison pill by shareholders, Nevins of CWT reckons it was a smart move. Falling foul of the derivatives market can put future debt issues at risk, he says. "The CFO might still get the issuance off, but buyers may add 20 or 50 basis points on to it just to let him know that they haven't forgotten."

Cablecom: A Risky Bet
As Swiss cable group Cablecom has shown, derivatives players don't always hold sway. After it was taken over by U.S.-based Liberty Global, Cablecom began buying back its debt. Betting that the firm would sweep up all of its bonds, some hedge funds took large positions as sellers of default swaps. If bonds disappear, default-swap sellers continue to collect premiums without risking a payout in the event of default.

When the news broke that Cablecom would issue new debt, guaranteed by holding company UPC, a lower-rated credit, the price of protection (and risk of default) shot up, leaving default-swap sellers with large notional losses. Hedge fund BlueMountain was among those on the wrong end of this trade, and issued angry statements urging Cablecom to reconsider its actions, hinting that the company deliberately boosted the value of default swaps in return for support from derivatives buyers for its subsequent bond issue.


According to Jamie Stuttard, a credit portfolio manager at Schroders in London, the company was right to dismiss BlueMountain's concerns, because bets on "succession events" made by default-swap sellers have "almost random outcomes and are a strategy we think should be left to gamblers in Las Vegas."

Special Delivery
Default swap-driven manipulation of bond markets now has a high-profile test case. In May, hedge fund Paulson & Company complained to the SEC in the US that Bear Stearns was buying ailing sub-prime mortgages at inflated prices in order to avoid paying out on the mortgage-backed default swaps it sold. This is neither sanctioned nor prohibited by the International Swaps and Derivatives Association, the industry's self-regulating body.

Whatever the outcome of the case, companies are increasingly aware that they will start running into default-swap players at times of takeovers or restructurings. One European finance executive who was about to launch a bond buyback recently noted, "There was no lobbying by the credit-default swap holders but we went through the thought process of what their position may be." Thus the tender offer price for the buyback and a new debt package were set in a way that would "avoid any disruption."

Habib Motani, a partner at Clifford Chance in London, notes, "When our lending team puts a loan together, they are asked whether it will be deliverable under a credit derivative. If not, then very often it will not be suitable." This wasn't the case a few years ago, he adds.

Recent research from the Federal Reserve Bank in New York shows that greater use of credit derivatives by banks generally means better borrowing terms for companies. And although recent market turmoil has put the brakes on the flow of credit, it is also chasing lenders — especially banks stuck with lots of LBO debt on their balance sheets — into the default-swap market to hedge their loan exposure. Like it or not, CFOs will increasingly be forced to deal with the default-swap gamblers.




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