Decoding Derivatives - Q1 2020

The McClatchy Company (MNI) Mellows Out

For a name on which $380 million was written at the time of the credit event and that had attracted some publicity in 2018, the scarcity of unsecured bonds (only around $15 million) surprisingly did not have a negative impact on the final price in the auction. This is despite the potential presence of opportunistic credit default swap (CDS) protection sellers who could have had an incentive to submit high physical settlement requests in order to drive up the final price in the CDS auction since trades would then have settled at much higher levels. This would not have been dissimilar to what happened in Sears in January of 2019.

To the contrary, the starting price for the auction was kept relatively low (at 5.375), a sign that dealers felt they could get their hands on the unsecured paper at that price (despite pre-trading in the unsecureds at much higher levels). The price then went further down to land at 2.0, driven by a relatively large net open interest to sell deliverable obligations of around $62 million. This means that CDS protection buyers (selling the debt in the auction) delivered arguably more valuable paper (e.g., third-lien notes) on settlement of at least 75% of the trades formed in the auction.  One cannot exclude the possibility that a large CDS protection buyer provided supply to keep the final price low (and monetize more value out of its CDS positions). All in all, however, this does not seem to be an unreasonable outcome based on the actual value of the “cheapest to deliver” unsecured debt in MNI’s bankruptcy, a good sign for the CDS product in general.

Market Manipulation … Really?

Based on credit default swap (CDS)-related strategies over the past couple of years, to many it appears that any swing in CDS spreads sparks cries of market manipulation and nefarious conduct, a trend seen both in the press and in the courts.  Is the CDS market in the midst of rampant (and illegal) manipulation or are we simply seeing misplaced outcries over bona fide investment strategies? Absent fraud or deception, where trading in a highly reactive market has the collateral impact of causing price movements, such movements are par for the course. Is the Commodity Futures Trading Commission barking up the wrong tree? In our article, we discuss the narrow scope of the market manipulation statutes and highlight the high bar regulators must meet.

CDS Activism Goes for a Pint Across the Pond

In a relatively rare (at least publicly reported) move for a U.K. reference entity, pub company Stonegate appears to have engaged with CDS market participants to structure a refinancing to avoid an orphan CDS. This could constitute a geographical expansion of CDS opportunism seen predominantly in the United States in the past few years. Participants in the European CDS market have long complained about orphan CDS issues in which debt restructuring or reorganization would leave too little debt outstanding to settle the CDS contract. This was an issue in Thomas Cook, in which a corporate reorganization would have wiped out debt eligible to settle the CDS contract, orphaning $290 million in CDS protection. Should the contract be reformed to broaden succession events and avoid orphaning, or should this be left to market participants to fix by engaging with the reference entity, resulting in potential accusations of market manipulation? Let us know what you think.

Repo Market Turbulence May Not Be All Doom and Gloom

With the Secured Overnight Financing Rate (SOFR) set to replace the London Inter-bank Offered Rate (LIBOR) in 2021, recent market turbulence in the overnight repo market has rightly piqued the interest of those still unsold on SOFR. A lack of purchasers in the overnight market has resulted in significant injections of capital from the Fed in an effort to stabilize the critical rate. Following intervention by the Fed in September 2019, further diminished liquidity has arisen in Q1. On closer inspection, however, low liquidity in SOFR products may simply be a result of prevailing market conditions and thus reflective of true economic decision-making. Moreover, as more participants enter the sponsored repo market (which itself poses interesting risk and settlement issues), limited liquidity may prove to be a transitory hiccup rather than a structural flaw. Given SOFR (a rate intended to be a true reflection of market forces) is preferred to a policy-based LIBOR, the low liquidity we have seen due to supply and demand in various corners of the market may actually be more vindication of the SOFR project as an accurate reflection of the market.

Subcode: Decoding the FICC 

The Fixed Income Clearing Corporation (FICC) was established to ease pressure on dealer balance sheets. The FICC essentially provides dealers access to overnight funding from money market funds, with all trades being routed and cleared through the FICC and offsetting transactions being netted. These trades are known as sponsored repos and have become increasingly popular since the market was opened to money market funds in 2017. FICC repo trading is not entirely free of risk though, since market participants may face exposure to the failure of their sponsored members, depending on the location of their cash and securities when the music stops.

Is CDS the Answer? Do the Math

Where a CDS on a reference entity exists, it is often used as a yardstick for the probability of default of the reference entity and the expected recovery of a creditor. Therefore, when CDS spreads swing, one would expect those swings to be reflective of changing market expectations of default, recovery or both. In a recent paper, NERA consultants examined the link between CDS spreads on RadioShack and events leading up to its ultimate bankruptcy in 2015. The ability to analyze empirical data on CDS spreads against the various pre-default/pre-bankruptcy events gives some insight into which events resulted in changes in market expectations of default probability or recovery. By understanding which events may or may not have been driven by CDS considerations, one may be able to understand whether CDS was a factor in the company’s or its lenders’ decision-making.

Muni CDS: Threat to a Market?

The muni CDS market is relatively young and small. However, that has not stopped the emergence of CDS-driven strategy in an attack on the credit of the State of Illinois. Plaintiffs John Tillman (a taxpayer) and Warlander Asset Management (holding $25 million in Illinois G.O. bonds) sued to invalidate more than $14 billion in general obligation bonds, the recent issuance of which, the plaintiffs claim, violates the Illinois Constitution. Kramer Levin’s amicus brief alleged, and Warlander’s counsel admitted under judicial questioning, that Warlander held a substantial CDS position that would pay off if the bonds were invalidated. The court dismissed the constitutional challenge as lacking reasonable grounds. Tillman (but not Warlander) has appealed, arguing that the hearing court prematurely ruled on the merits of his challenge. Warlander’s strategy — litigating invalidity to cause a default that would trigger CDS — poses particular problems for the municipal bond market. The mere pendency of such litigation may impede a municipal issuer’s ability to borrow every year (as most municipalities must) by deterring municipal officials from certifying the validity of the issuer’s debt for fear of personal liability. The Tillman litigation may spark a movement to “fix” the muni CDS product while it is still in its infancy.

In Case You Missed It

The 2014 Credit Derivatives Definitions have been updated to address Narrowly-Tailored Credit Events. The changes became effective on January 27, with 1,358 parties adhering to the protocol. It is also clear that, despite this significant action from the market, regulators continue to look into opportunistic CDS strategies and other possible issues in the market that may need to be fixed.