Matt Levine’s Money Stuff: Not Everyone Likes CDS Creativity
published Jan 18, 2018 8:39:36 AM, by Matt Levine
(Bloomberg View) –
We have talked a few times recently about Hovnanian Enterprises Inc., which got favorable financing from Blackstone Group’s GSO Capital Partners through some credit-default-swap market machinations. GSO had bought CDS protection that would pay off if Hovnanian defaulted. Hovnanian will refinance its debt with a series of new instruments, including a favorable new term loan from GSO but also some new 22-year bonds with a comically below-market interest rate of 5 percent, which should trade at something like 50 cents on the dollar. Those bonds — along with more valuable bonds, adding up to an attractive total package — will be issued in exchange for some of its old bonds, pushing out its debt maturities and relieving some of its financial pressure.
But it also plans to buy (through an affiliate) $26 million worth of the old bonds, keep them outstanding, and default on an interest payment just to those bonds. Hovnanian will default on a payment it owes to itself, but keep paying off all of its external bondholders. This shouldn’t bother the bondholders, but it should trigger the credit-default swaps. And because some of the new bonds will be worth something like 50 cents on the dollar, those credit-default swaps (which pay out more the less Hovnanian’s bonds are worth) should be worth a lot. GSO will make a nice profit on its CDS, and will use some of that profit to subsidize some cheap financing for Hovnanian.
I once wrote about it: It’s quite a trade! One thing that is elegant about it is that it doesn’t require Hovnanian to “really” default: It has to miss an interest payment, but only an interest payment due to its own affiliate. (Outsiders who keep the 8 percent bonds after the exchange offer will still get paid.) No third-party creditor will be harmed by the default, so no bond or loan investor will have any cause to complain, or to refuse to finance Hovnanian in the future, or to sue Hovnanian’s directors for defaulting in bad faith. The only people harmed by these machinations will be the people who wrote credit-default swaps — and I suppose it is reasonable for Hovnanian not to care too much about what they think.
That was a bit hasty: You can get sued for anything. And so last week Solus Alternative Asset Management LP, a hedge fund that wrote credit-default swaps on Hovnanian, sued the company, its chief executive officer and chief financial officer, and GSO, for … something? The problem is that Hovnanian really isn’t doing anything to Solus. Solus wrote some CDS on Hovnanian, but Hovnanian wasn’t a party to that CDS and has no obligations to Solus under it. So the lawsuit consists of a lot of hand-waving and shouting about fraud. “The Defendants, directly and indirectly, by the use, means, or instrumentalities of interstate commerce and/or of the mails, engaged in deceptive or manipulative acts to engineer a fraudulent, sham payment default by Hovnanian and the issuance of a Rigged Bond whose off-market terms will drive its price well below par and result in an inflated recovery on Hovnanian CDS contracts,” says the complaint, to which Hovnanian might reasonably respond “yeah what of it?” Hovnanian isn’t defaulting, fraudulently or otherwise, on a payment owed to Solus; it’s not forcing Solus to buy any bonds, rigged or otherwise. Solus’s objection is strangely aesthetic: Hovnanian’s new bonds are so ridiculous that they just shouldn’t be allowed to exist.
To put the absurdity of the Rigged Bond into perspective, there is not a single high-yield issuer rated by Moody’s or S&P with Hovnanian’s credit rating (or worse) that has outstanding unsecured debt maturing more than 10 years in the future, let alone the 22-year maturity proposed for the Rigged Bond. Any arms-length investor willing to lend money to a company for that extended length of time typically demands a higher interest rate to compensate them for committing capital for that long; yet, the annual interest rate on the Rigged Bond is half of the 10% interest rate on Hovnanian’s own secured bonds that would mature eighteen years before the Rigged Bond. Indeed, given these wildly off-market terms, credit analysts at global investment banks have speculated that the Rigged Bond will trade at no more than 50 cents on the dollar while the company’s legitimate unsecured bonds are currently trading around par.
Perhaps more seriously, there is a claim that Hovnanian’s exchange offer documents are misleading, “disclosing obliquely that its agreement to default on interest owed on its notes ‘may’ trigger a credit event when, in fact, the true but concealed nature and purpose of the transaction is a commercial bribe intended to trigger a CDS credit event for the sole purpose of enriching GSO in exchange for the provision of below-market financing.”
“The intended effect of Hovnanian’s complicity in GSO’s scheme,” says Solus, “is to deliver hundreds of millions of dollars of illicit CDS payouts to GSO and other CDS protection buyers at the direct expense of innocent CDS protection sellers, like Solus.” There is a lot of that sort of emotional appeal: Think of the poor innocent CDS protection sellers! “In selling CDS protection on Hovnanian debt,” the complaint says, “Solus relied upon a normally functioning market in which payment defaults occur as a result of actual financial distress, and borrowers endeavor to abide by their contractual obligations.” But again that is no concern of Hovnanian’s. Hovnanian didn’t invent the CDS market, or buy or sell any CDS itself. Hovnanian never asked Solus or anyone else to sell CDS on itself; Hovnanian would have been perfectly happy if anyone who had wanted to invest in its credit had just bought its bonds rather than entering into zero-sum third-party derivative side bets. But they entered into the side bets, and GSO found a way to turn those bets into money for Hovnanian (and GSO), and Hovnanian took it. It’s hard to see why it wouldn’t.
I would not have expected, at this late date, to laugh out loud multiple times at an article about scandals at Uber Technologies Inc. and the fall of its co-founder and former chief executive officer Travis Kalanick. I would have thought that all the funny and terrible and so-terrible-it’s-funny news was out by now. But this Bloomberg Businessweek story by Eric Newcomer and Brad Stone is titled “The Fall of Travis Kalanick Was a Lot Weirder and Darker Than You Thought,” and it is the rare story that, at least for me, lives up to its second-person headline. For instance, remember that embarrassing video of Kalanick arguing with an Uber driver? Here’s how Kalanick reacted when two executives showed it to him during a break from a meeting about how terrible Uber’s culture was: As the clip ended, the three stood in stunned silence. Kalanick seemed to understand that his behavior required some form of contrition. According to a person who was there, he literally got down on his hands and knees and began squirming on the floor. “This is bad,” he muttered. “I’m terrible.”
That … yes, that is weirder and darker than I thought, fair play. One of the executives at that culture meeting was Jeff Jones, Uber’s president, who quit after six months. “Jones seemed so eager to leave the company that he declined to negotiate an exit package, potentially leaving millions of dollars behind.” I picture him fleeing the building in the dead of night, taking with him only the clothes on his back, stopping only to give an exit interview “excoriating Kalanick’s shotgun management style and unwillingness to listen.”
Kalanick’s unwillingness to listen extended to the White House. Here’s how he declined a spot on one of President Trump’s business advisory councils: Ultimately, Kalanick decided the whole thing wasn’t worth the trouble and his minders set up a call so he could politely say no to Trump. A chronic pacer, Kalanick walked away from his desk at the appointed time. The first call from the White House came—and went to Kalanick’s voicemail. Then came the second call. Trump was on the line, and Kalanick walked into a glass-walled conference room to deliver the news. The conversation apparently went as one would expect. Kalanick emerged to tell his colleagues that the president was “super un-pumped.”
That is the purest possible anecdote about our weird modern age. One day soon, when the singularity comes and the robots overthrow humans as masters of the Earth, government and military leaders will learn about it from a phone call from a scruffy young techbro CEO. He will inform them that humanity’s time has come to an end, give a brief explanation, hang up, turn to his colleagues, and say: “The president was super un-pumped.” It will be a fitting epitaph on human civilization.
I was pretty blasé yesterday about all the banks who lost money on a margin loan to shareholders of Steinhoff International Holdings NV, whose shares “lost about 90 percent of their value last month after it announced Dec. 5 that it had uncovered accounting irregularities.” I pointed out the competitive pressures on banks to be at least as commercial as their peers in order to win deals, pressures that make it hard to say no even to pretty hairy deals. But this, I think, is too blasé:
“Once in a while, something doesn’t turn out the way we want because that’s what the definition of taking risk is,” Bank of America CEO Brian Moynihan told reporters Wednesday, saying the incident wouldn’t change the lender’s risk appetite.
Sure, fine, yes, if a meteor had hit Steinhoff, you’d be like “eh, risk, amirite?” But what actually hit Steinhoff were accounting irregularities for which it had long been criticized. (“A decade ago, in a 56-page research report, analysts at JPMorgan Chase & Co. asked why Steinhoff’s accounts lacked ‘pivotal information’ about where it was generating revenue and why it appeared to focus on tax breaks rather than the actual business.”) Saying generically that one nine-digit loss won’t change a giant bank’s “risk appetite” is perfectly reasonable: Banking is a risky business, you will have losses, and your risk appetite should be based on your overall portfolio, not your single worst trade. But you want to learn something from missing a giant accounting problem in your due diligence. You want to make some changes to your processes. “Yeah sure we’re going to keep lending against shares of companies whose accounting we don’t understand, whatever, it’s just a few hundred million dollars” is not the right lesson to draw from Steinhoff.
Elsewhere: “The mysterious short seller who flagged financial irregularities dogging Steinhoff International Holdings NV has stepped out of the shadows.” And Morgan Stanley reported earnings this morning (earnings release, supplement), with record fees in wealth management but no mention of any Steinhoff loss. Was Morgan Stanley not part of the club?
Elsewhere in lending against opaque stocks:SharesPost, a leading liquidity provider to the Private Technology Growth asset category, today launched a new program that provides immediate liquidity for holders of private company shares and stock options.
SharesPost’s private stock loan program enables shareholders to borrow against their stock to generate liquidity and allows option holders to finance the exercise of their options. Rather than selling shares to gain liquidity or using personal capital to exercise options, SharesPost will structure a loan customized to each individual and allow them to retain the potential upside in their holdings.
Private markets, I like to say, are the new public markets, and if you can get margin loans or securities-based loans against your publicly traded shares, it seems a little weird that you can’t get those loans against your Uber shares or whatever. And now you can. Lending against private stock is a little more complicated than lending against public stock, though. For one thing, it’s harder to measure the value of private stock if it doesn’t trade much, though of course the big unicorn stocks do trade and have fairly well-established market values; one way to deal with this is just to have lower loan-to-value ratios, say lending 33 percent of the value of your stock instead of 50 percent.
For another thing, public-stock margin lenders can always seize the collateral when it hits a margin trigger, and then sell it to recover the value of their loans; that’s harder to do with restricted private stock that doesn’t trade on an exchange. So the SharesPost platform’s loans won’t be margin loans: They are non-recourse loans with no margin calls; if the stock goes to zero, the lender just eats the loss. In exchange for taking this stock-price risk, the company told me, the lenders will get some upside in the stock. In derivatives terms, the loan looks a bit like a very wide collar: If the stock declines by more than two-thirds, the lender is stuck with the rest of the losses; if the stock goes up, the lender gets some of the gains. It’s not quite a traditional margin loan, but it is a pretty common public-markets product, and now you can get it in unicorn flavors as well.
“Useless Ethereum Token” is useless. You can tell from its name, and from its website (which says “Seriously, don’t buy these tokens”), and from its logo (which “literally shows the middle finger to its buyers”). It doesn’t matter:
Yet, despite the myriad warnings issued by its own promoters, the total value of UET rose as high as $350,000 earlier this month as buyers jumped in. At $0.04490 apiece, UET has risen by more than 240% in the past three months, against bitcoin’s 70% rise, according to CoinDesk.
That $350,000 market capitalization is nothing compared to DentaCoin, “the blockchain solution for the global dental industry,” which is even sillier than UET and whose total value crossed over $2 billion earlier this month, but still. That is $350,000 of value created out of thin air, just by introducing a confessedly useless token that doesn’t do anything.
It is however a bit unnerving to compare UET to bitcoin. Bitcoin is a genuine technical innovation; UET is a joke. Bitcoin’s total value is in the hundreds of billions of dollars; UET’s is in the hundreds of thousands. But bitcoin doesn’t do anything either. The thing you can do with bitcoin is: transfer it to someone else in exchange for money, goods or services. That’s what you can do with UET too. The basic technology of UET — tokens transferable over a decentralized blockchain — is not too different from the technology behind bitcoin. (Because it is largely copied from bitcoin.) UET — like plenty of other joke cryptocurrencies, starting with Dogecoin — just repeats bitcoin as farce. Most of the jokes are worth real money.
Why? Well: Juraj Kontuľ, a Slovak cybernetics student, has been trading cryptocurrency for four years, and bought a few dollar cents worth of UET this month when it briefly traded on HitBTC, a Europe-based cryptocurrency exchange.
He did it “to reward the guy for the work he did and the laughs he brought with the project, surely not only for me,” he said.
Mr. Kontuľ says he has made $300 from his tiny initial punt.
“I believe that the price was driven up mainly by the ‘crypto millionaires’ that were just having fun like anyone else, and maybe some speculators that wanted to make a quick profit,” Mr. Kontuľ added. “Let’s face it, the crypto community can pump up the price of anything.”
People bought it because they found it aesthetically appealing, or because they thought someone else would buy it for more money and they’d make a profit. That’s not too far from why people buy bitcoin. Oh of course people also buy bitcoin because widespread belief in bitcoin makes it useful as a store of value and possibly as a medium of exchange, but that is just a different way of saying the same thing. If everyone decided to use UET, it would be an excellent store of value, and the people who bought it early would be billionaires. The joke currencies are parodies of innovative cryptocurrencies like Bitcoin and Ethereum, but they are also distillations of them. The reason bitcoin is worth a lot of money is because people think it is worth a lot of money. The joke currencies say: But what if people thought we were worth a lot of money?
Here is some more crypto sludge: “Bitconnect, which has been accused of running a Ponzi scheme, shuts down.” “Bitcoin Watchers Are Blaming the Slump on the Moon.” Elsewhere in bitcoin astrology: “‘Bitcoin has held the 100-day since 2015, so you MUST sell it below there,’ Ross wrote in report Wednesday. ‘You have to respect a break below that level as your final warning.'” (And: “The calls represent an about-face from Ross’s position less than a week ago, when he recommended buying Bitcoin, Ether, Ripple, and Litecoin.”) But: “Bitcoin Holds Ground as Frantic Rally Sets $10,000 Support Level.” “Cryptocurrency Crash Sparks Bitcoin’s Nouveau Riche to Run to Gold.” Here’s some mark-to-market on the Winklevoss twins’ bitcoin wealth.
Here’s Scott Alexander on crypto-dating: “So the most interesting and distinguishing feature of Luna, at least to start with, might not be the tokens, or the incentives, or the machine learning. It might be that it’s a place you can go to meet the sort of people who want to date on the blockchain.” And here is a theory from Matt Klein: “It’s possible the recent price collapse below $10,000 per bitcoin is part of a coordinated effort by regulators to apply unconventional pressure techniques on North Korean elites.”
People are worried that people aren’t worried enough.
Sure:“The fact that the fear is gone is the main reason why we should be worried,” Joachim Fels, a global economic adviser at Pimco, told Bloomberg TV on Wednesday from Newport Beach, California. “That means most investors are now pretty fully invested and that means they will want to get out if the markets start to correct — exacerbating the downdraft.”
As main reasons for worry go, lack of fear is somewhat below, you know, global nuclear war, but it’s on the list somewhere I guess.
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Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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