Greek Debt Negotiations – Opa!

Posted on February 1, 2012 by

I’ve been following the Greek Debt Negotiations and it’s been a really fascinating story. It’s amazing how much the derivatives market has complicated the process.

Normally when a country defaults, a debt exchange often takes place. That is the original creditors would trade in their old debt for new debt with new payment terms and usually a reduction in the amount of principal on the coupon (“haircut”). A creditor will usually agree to an exchange like this if it thinks that it won’t get paid any other way, and collecting 50 cents is better than getting nothing.

There are several types of creditors: bilateral (individual countries), multilateral (e.g. World Bank and IMF), commercial banks, and other private investors. Each of these creditors have different incentives to settle with Greece and move on from the default. Some are more willing than others. In particular, some private creditors have had their situations complicated by their hedging positions.

Enter the credit default swaps…

So as explained earlier, a credit default swap (CDS) can be thought of similar to a type of insurance policy, when the debtor defaults, the creditor swaps positions with the CDS counter-party and is effectively made whole by the counter-party.

Private sector creditors are being represented by the IIF, Institute of International Finance, a global association of financial institutions that has the incredibly difficult challenge of representing the private creditors in the negotiations.

Here is where things start to get complicated, every creditor has a different agenda. And based on how the debt agreements are structured (specifically whether or not there is a pari passu clause or collective action clause) some, all or most of the creditors are required to approve a deal. Given that a private creditor could withdraw its permission to allow the IIF to negotiate on its behalf, the IIF is tasked with balancing many competing interests.

What are those competing interests? Well it depends on who is holding the debt.

If its a commercial bank with significant interests in doing business with the government of Greece or doing business in Greece, they are more likely to go along with the consensus and settle the matter as quickly as possible in order to preserve the relationships with the government.

If its a hedge fund or distressed debt fund who purchased the debt on the secondary market, it depends on the price they paid and their individual expectations of IRR which will dictate how hard they negotiate.

If its a pension fund (or a trust) with fiduciary obligations to its beneficiaries, they will have competing interests to ensure that they do not violate their obligations and get the best deal possible.

And it gets really complicated when any of these parties holds a credit default swap on the debt. Because if they hold a CDS, they may have an incentive to settle at a lower amount in order to trigger a default under their agreement and then be made whole. So instead of settling for a 50% cut or a structure that doesn’t technically qualify as a default, they may be incentivized to actually structure a deal which is likely to trigger their protection.

Which begs the question, when is a default a default in a CDS? This is where things continue to get murky because the CDS market is unregulated, each contract may have differences in it. Now its most likely the case that a 50 or 60% haircut may be enough to trigger a technical default and initiate the CDS protection; however, many of the private creditors don’t want this because they are still trying to determine what their potential exposure is on the CDS side of things. It’s likely that many of the creditors are on both sides of the swaps or represent clients who are on the other end of a swap. So even within a bank, there may be conflict on which way to negotiate. And to make matters worse, the CDS counter-parties, who aren’t readily identifiable, don’t have a separate seat at the table.

Opa!

Posted in credit default swaps | Tagged , , , ,

Paris Time Lapse Photography

Posted on April 26, 2011 by

I saw this earlier today and thought it was an excellent video. It was done entirely using still photographs and it has music from The XX.

Le Flâneur (music by The XX) from Luke Shepard on Vimeo.

Posted in Photography | Tagged ,

Treasure Island

Posted on April 21, 2011 by

I’m going to use this blog as a proxy for my random musings and thoughts.  I’m calling it Tired of Doctors because, quite frankly, I’m tired of doctors, I mean really, who enjoys going to the doctor?

I’m currently reading Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens by Nicholas Shaxson.  The prologue begins in Gabon and tells the tale of how interconnected “Western” interests are to African nations, and in particular, corrupt African leaders.  I’ve only made it through a few chapters so far, but I must say the book is quite eye-opening.  The amount of money that passes through offshore financial centers is staggering.

I started reading this book as I’ve been following the stories about the stolen assets from the recently fallen North African leaders such as Ben Ali, Mubarak, and Gaddafi (anyone who can tell me how to properly spell his name would be much appreciated).  The amounts of money that have been allegedly misappropriated by these leaders and their families is staggering.  For Tunisia’s Ben Ali, it is estimated that his family wealth is over 12 billion US Dollars.  For Mubarak, it is estimated that his family wealth is over 70 billion US Dollars.  Gaddafi’s wealth is unknown, but I’ve seen reports that as much as 30 billion US Dollars was frozen in the United States alone.  For comparison, the entire capital base of the African Development Bank is less than the combined wealth of these three leaders.

I’m curious to see where Shaxson goes with this book, part of me wonders if it will lead to any meaningful reform or whether it will serve as a blueprint for those who have wanted to shelter money but don’t know where to begin.

I’ll post more updates about the book as I continue to read.

Posted in Books, Money Laundering, Stolen Asset Recovery

Derivatives Don’t Cause Massive Losses. Only People Cause Massive Losses.

Posted on October 17, 2008 by

Such was the thrust of testimony before a Senate committee this week by Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), and Richard Lindsey, former president of Bear Stearns’ brokerage unit, regarding the role of credit default swaps (CDSs) in the current economic crisis. Said Lindsey,

“[R]isks [are] not created by derivatives. They [are] created by
individuals or corporations making bad choices when using derivatives.”

Given recent events, perhaps it would be churlish to point out that derivatives, particularly when combined with massive leverage, can magnify and concentrate the effect of those bad choices (as the travails of AIG have amply demonstrated). Regarding CDSs, “Black Swan” author Nassim Taleb noted this week,

“We refused to touch credit default swaps. It would be like buying
insurance on the Titanic from someone on the Titanic.”

Even as TARP has morphed from an asset purchase program to a recapitalization plan, financial market turmoil and volatility remain unabated. Many observers blame the fear that continues to grip the financial world on the dawning realization of the threat posed by the $62 trillion (by some accounts) CDS market. The exponential growth of the CDS market over the past few years, its opacity and lack of regulatory control, and the fear of counterparty risk in the wake of Lehman’s failure have made CDSs the latest instrument to raise the spectre of further massive losses at financial institutions and hedge funds. As investors, politicians and regulators cast about for root causes of the current crisis and steps that need to be taken going forward, a harsh light is being shone on CDSs.

CDS proponents are pushing back. Messrs. Pickel and Lindsey, while conceding the need for some changes in the market (such as a central clearing house for trades), reject the notion that direct government oversight of the market is necessary or appropriate. Similarly, The Depository Trust and Clearing Corporation issued a statement last week that strongly disputed the size and opacity of the CDS market, claiming that the $62 trillion notional value amount represents double counting (i.e., adding in both sides of a single trade), and that the real number is approximately $35 trillion. The DTCC also takes issue with the potential losses that will result from Lehman’s bankruptcy. While some analysts have that predicted total losses arising from protection sold against a Lehman default could be as high as $400 billion, the DTCC contends that virtually all of the Lehman trades will net out, and that required payouts will not exceed $6 billion.

We will find out very shortly who is correct. The financial markets are now directly confronting the concerns raised months ago in this space (and many others). An auction conducted last week by ISDA produced a settlement price for Lehman debt of less than ten cents on the dollar, which means that Lehman protection sellers must pay their counterparties over 90% of the par value on the underlying bonds. Did protection sellers properly hedge their risks by buying protection coextensive with their potential exposure? If they did, will their counterparties be able to make good?

Settlements are required to be made next week, on October 21st. After that, the financial markets can begin to focus on the potential impact of the WaMu CDSs. That settlement auction is scheduled for October 23rd.

Posted in Finance, Overhedged | Tagged , , | 1 Comment

Perils of Paulson

Posted on September 22, 2008 by

Henry Paulson and Ben Bernanke may be escaping from the precipice of one horrific calamity, only to be breathing a sigh of relief just as an even worse catastrophe looms. The plan to buy distressed mortgage related assets and derivative products, referred to by some as TARP (the Troubled Asset Relief Program) and by others as MOAB (the Mother of All Bailouts), may provide some short term relief to the global financial markets, which perhaps will suffice to head off greater disaster. However, putting aside the concerns raised regarding the wisdom and efficacy of the proposal, the larger question remains as to how to mitigate the threat posed by the still-completely-unregulated $62 trillion credit default swap market.

As discussed in this space before, a credit default swap (CDS) is a swap agreement whereby the holder of debt may purchase protection from a third party against the debt issuer’s default. The seller thereby takes on the credit risk of the issuer, and the buyer replaces the credit risk with counterparty risk. As CDSs have evolved from hedging devices into speculative instruments (buyers making short bets without actually owning the underlying debt), the market has grown exponentially. The perils posed by such rapid growth in an unregulated over the counter market were fast becoming apparent last year. Several months ago, I wrote:

Given both the immense size of the CDS market and how poorly risk in other asset
classes was assessed and priced over the past several years, CDS counterparty
risk is accurately being called the “sword
of Damocles” hanging over the financial services industry. The term
“counterparty risk” will likely soon move alongside “subprime borrower” as a
disquieting addition to the financial lexicon.

Fear of exposure to the CDS market led to the Federal Reserve’s willingness to backstop in part the JP Morgan takeover of Bear Stearns and the rescue of AIG. Lehman Brothers was permitted to fail because its CDS exposure appeared to present less of a systemic threat.

CDS market participants and the International Swaps and Derivatives Association have been working for months to increase transparency and reduce counterparty risk. As of today, there are no standardized settlement procedures, and the market has never been forced to deal with a major default. The obvious need is for the creation of a central exchange. Unfortunately, the development of such a clearing system will probably not be in place until early 2009.

In the meantime, it is anyone’s guess where the major fault lines lie. The bailout of Fannie and Freddie triggered “credit events” under an unprecedented number of CDS contracts – as much as $1.4 trillion by some estimates. However, because the conservatorship effectively assures full payment of the underlying Fannie/Freddie debt, the settlement amounts on the trades (the difference between par and market value that the CDS seller owes to the CDS buyer) should be $0. Accordingly, there will be relatively little economic impact as the major market participants seek to sort this all out.

The financial markets may not be so lucky the next time a company whose debt is the subject of over $1 trillion in CDSs goes into default. If, for instance, one of the Big Three automakers were to seek bankruptcy protection, its bonds will almost certainly be worth substantially less than par, and the settlement amounts owed by CDS sellers to CDS buyers could be overwhelming. While most trades will net out, the failure of a financial institution or hedge fund to make good on its obligations as a protection seller could trigger another financial crisis equal in scope or greater to what has been faced over the past two weeks.

It also gives rise to the even more unsettling possibility that the government may be forced to step in and prevent such a major bankruptcy filing. The perils continue. TARP / MOAB may be just the beginning.

Posted in Commentary, credit default swaps

Supreme Court Narrowly Construes State and Local Tax Exemption for Asset Sales in Chapter 11 Proceedings

Posted on June 19, 2008 by

On June 16, 2008, the United States Supreme Court, in Florida Dept. of Revenue v. Piccadilly Cafeterias, Inc., Case No. 07-312, held that a bankruptcy court may not exempt a debtor from state transfer taxes on the sale of its assets prior to confirmation of its Chapter 11 plan. In a 7-2 decision, the Court reversed the order of the Bankruptcy Court for the Southern District of Florida (the “Bankruptcy Court”), which applied Section 1146(a) of the U.S. Bankruptcy Code, formerly designated as 1146(c) prior to the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, to exempt Piccadilly Cafeterias, Inc. (“Piccadilly”), from documentary stamp taxes imposed by the Florida Department of Revenue (“Florida”), on the sale of substantially all of its assets through a public auction. The holding is anticipated to affect billions of dollars in state tax revenue collection, and it will have a significant impact on creditors of corporate debtors that elect to dispose of their assets in pre-confirmation sales under Section 363 of the Bankruptcy Code.

Pre-confirmation asset sales under Section 363 of the Code are common in Chapter 11 cases, and the trend toward such sales has grown stronger over the last few years. However, the Section
1146(a) tax exemption has not been uniformly applied. Section 1146(a) provides as follows:

The issuance, transfer, or exchange of a security, or the making or delivery of
an instrument of transfer under a plan confirmed under Section 1129 of this
title, may not be taxed under any law imposing a stamp tax or similar tax.

Piccadilly sought approval from the Bankruptcy Court for the sale of its assets prior to confirmation of its Chapter 11 plan, over Florida’s objection for nonpayment of taxes. The Bankruptcy Court, following the reasoning of courts in the Second Circuit, interpreted the exemption on a “transfer under a plan confirmed,” to include asset sales preceding confirmation of a Chapter 11 plan, so long as necessary to confirmation of the plan, and held that the sale under Section 363 of the Code was exempt from the imposition of Florida’s documentary stamp tax. On appeal, both the District Court for the Southern District of Florida and the Eleventh Circuit Court of Appeals affirmed the Bankruptcy Court’s order.

Courts in the Third and Fourth Circuits had taken a different view, interpreting Section 1146(a) to apply solely to transfers effectuated through a confirmed plan. These courts have held that Congress intended to provide exemptions only for transfers “reviewed and confirmed by the court,” and thus a transfer “under a plan confirmed” contemplates only those transfers occurring after the date of confirmation.

The Supreme Court granted Florida’s petition for a writ of certiorari in order to resolve the disparity among the circuits. Florida argued in support of its appeal that the plain language of Section 1146(a) provides for a limited exemption from stamp and similar taxes on post-confirmation transfers made under the authority of a confirmed plan, and asked the Court to interpret Section 1146(a) as setting forth a simple bright-line rule.

On the other hand, Piccadilly advocated the conclusion that Section 1146(a) applies to pre-confirmation transfers that are “instrumental” to consummation of a Chapter 11plan. Piccadilly argued that the text of Section 1146(a) is ambiguous and the intent of the provision, as well as the Chapter 11 structure, is best carried out by a broader interpretation of its application.

Ultimately the Court was swayed by Florida’s argument that §1146(a) exempts only those transfers made pursuant to a Chapter 11 plan that has been confirmed. The Court held that this interpretation was “ [t]he most natural reading of §1146(a)’s text, the provision’s placement within the Code, and applicable substantive canons.” The Court particularly noted that “recognizing an exemption from state taxation that Congress has not clearly expressed” would offend fundamental principles of federalism.

This decision is unlikely to significantly deter the current trend of pre-confirmation Section 363 sales. However, while the ruling substantially benefits the tax collection efforts of state and local government authorities, it will impede the recovery efforts of unsecured creditors, who already generally receive significantly less than they bargained for when a company liquidates through Chapter 11.

Posted in Bankruptcy, Supreme Court | 2 Comments

More on Hedge Funds and the U.S. Bankruptcy Process

Posted on May 29, 2008 by

Bear Stearns Funds

The denial of recognition under Chapter 15 of the Bankruptcy Code of the Cayman Islands liquidations of the Bear Stearns High-Grade Structured Credit Strategies Master Fund and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund (the “Funds”) was affirmed last week. Judge Robert Sweet of the U.S. District Court for the Southern District of New York affirmed the decision last September of Bankruptcy Judge Burton Lifland that the Funds’ centers of main interest (COMI) were in the United States, rather than the Cayman Islands. Although there was no opposition to the requested relief, Judge Sweet strongly validated Judge Lifland’s view that the Joint Official Liquidators of the Funds failed to meet their burden of establishing the Funds’ COMI outside of the United States.

Many hedge funds are domiciled outside of the United States. For such a fund that fails, commencing a case in its jurisdiction of formation, and then utilizing Chapter 15 of the Bankruptcy Code to protect assets located in the U.S., can offer a flexible, lower-cost alternative to the commencement of a Chapter 11 case. However, what may be in the best interests of a fund’s sponsors and managers may not coincide with the interests of its investors and creditors. Considering the substantial amounts (nearly $2 trillion) currently entrusted to hedge funds, Judge Sweet aptly noted:

The process by which the financial problems of insolvent hedge funds are resolved appears to be of transcendent importance to the investment community and perhaps even to the society at large.

For now, it is clear that the parties entrusted with the liquidation of such funds will need to establish that the fund’s business is truly centered outside of the U.S. (or, at the very least, that it has significant operations outside of the U.S.). Otherwise, they will need to resort to the more burdensome requirements of a Chapter 11 case.

Rule 2019 Disclosure

Rule 2019 of the Federal Rules of Bankruptcy Procedure requires certain disclosures by “every entity or committee representing more than one creditor or equity security holder[.]” As noted in an earlier post, the question of whether Bankruptcy Rule 2019 can be used to require members of ad hoc committees (which often consist of hedge funds) in Chapter 11 cases to disclose the amount that they paid to acquire their claims or interests remains a very hot issue right now. For a hedge fund, such information can be tantamount to disclosing a proprietary trading strategy. Unquestionably, some debtors and other interested parties are requesting such disclosures as a way to seek to neutralize aggressive groups of hedge funds.

Last year, in the Northwest Airlines case, SDNY Judge Alan Gropper held that a group of hedge fund equity holders represented by common counsel constituted a “committee” for purposes of Rule 2019. The equity holders were therefore required to provide information setting forth “the amount of claims or interests owned by the members of the committee, the times acquired, the amounts paid therefor, and any sales or dispositions thereof[.]” Judge Richard Schmidt in the Pacific Lumber Chapter 11 case subsequently reached the opposite conclusion on this question, and refused to require an ad hoc group of bondholders to disclose details of their trades of Pacific Lumber debt securities.

Judge Kevin Carey in the highly influential Delaware bankruptcy court has now weighed in. Ruling on a Rule 2019 request in the Sea Containers Chapter 11 case, Judge Carey agreed that the ad hoc bondholders did constitute a “committee” for purposes of Rule 2019. However, he did not require disclosure of the amounts paid in specific trades. The outcome is probably a positive one for the Sea Containers bondholders, but will almost certain engender more Rule 2019 disclosure requests in other major Chapter 11 cases.

Posted in Bankruptcy, Chapter 15, Commentary, Rule 2019