4.22.2009

The Rise of Empty Creditors?

Bankruptcy investing and distressed debt investing is a difficult and complicated process. Creditors and debtors usually have different motivations for their actions. Different creditors have different motivations for their actions. Some creditors like to take back equity to gain control of the company; others (like CLOs) want reinstated debt. Other want the company to be liquidated and to receive a fat dividend. Debtors generally want to stay alive. If management can hang onto their seats, they can be granted cheap options on the reorganized stock at the expense of other creditors. I have seen very few cases where a management walks into the court and says - "Judge, I want to liquidate." It just does not happen.

In summary - always, always look to incentives of various stakeholders.

Daniel Gross penned an interesting piece for Newsweek entitled "The Rise of the 'Empty' Creditor" Generally he brings up some fair points, unfortunately I have to disagree with him on a few others.

For those that are experienced in the CDS market, please skip this paragraph. From those that do not play in the CDS market on a regular basis, there are certain trades investors put on to exploit perceived mispricings in the market. One of these trades is a basis trade. Now there are many different flavors of basis trades, but for this post, I am focusing on one in particular. In essence, one buys credit protection, as well as the underlying bond to capture a point or yield spread in the underlying entity. For example, at one point in the not too distant future, you could buy Neiman Marcus bonds at 60 cents on the dollar, but credit protection at 25 points up front and capture a positive spread (i.e. the bonds were paying a higher coupon then the CDS insurance carry). In essence, if Neiman Marcus filed tomorrow, I should make money on that trade.

Why? If the CDS auction goes off at 30 points (meaning, those who sold protection owe 30 points to the buyers of protection), the bonds theoretically should be worth 70 points (CDS Points Up Front + Bond Price should equal 100). I make money two ways on that trade. 1. My bonds move up 10 points and 2. My CDS widened another 5 points.

Now the next question you are going to ask is: why doesn't everyone do this? Well, a lot of people do this trade - unfortunately, the market gets wacky sometimes. Especially in the illiquidity that is distressed debt securities. You can lose billions and billions of dollars (on a mark to market basis) like Deutsche Bank did last year.

In the example above, I am indeed preserving my economic interest in hope the company to fail. More importantly - I am preserving my investors economic interest. Do I not have a fiduciary duty as an investor to generate the highest risk adjusted return for my investors?

The main point I take difference with in Daniel Gross' article is his take on Six Flags. We profiled Six Flags' debt in an earlier post. I completely disagree with his notion that bond holders (like Fidelity Investments) accept the tender offer. In the tender, bond holders are only to receive 58.3% of the new stock. Who cares if they have an offsetting CDS position - as they are splitting the rest of the post restructured equity with the converts and then giving the rest to the junior claimants, who should get nothing more than warrants at best. In reality, do you really think the common or preferred'd deserve anything? If I were Fidelity, I would hold out as well until a better exchange was offered.

And the reason GGP filed was because it was massively overlevered. Not because of the CDS market. Abitibi filed because its a asset heavy, cyclical company in a secularly decling business - these businesses file for bankruptcy in times like this. And when they come out of bankruptcy, with a cleaner balance sheet, in a better economy, creditors who saw a value proposition buying their debt on the cheap in or out of bankruptcy make money.

For whatever reason, the press always seems to shift the blame to hedge funds. Why not blame GGP's former CFO and CEO for levering up at the top? Why not blame Six Flag's former management for spending over a billion dollars on capex in the last 8 or so years with -95% return to shareholders. Hedge funds don't make companies go bankrupt - poor management, poor corporate governance, and poor financial policies make companies go bankrupt.

7 comments:

Dataman 4/22/2009  

I find your commentary fascinating and cannot wait to read the next one! Thanks.

Lawrence D. Loeb 4/22/2009  

You beat me to the punch, although with a different slant.

I was planning to write a post about the FT article referenced by Newsweek.

My thought is that it might be beneficial to the party writing the CDS to have the option of exercising the swap before an official default. This would provide the writer with the ability to try to minimize their loss, if they believed that an out of court debt exchange could provide greater economic returns.

This would, of course, require the option physical settlement (the way CDS were formerly settled). I don't know that such a process could be executed for exchange traded CDS (where the Government is pushing for as opposed to the traditional OTC market).

The CDS writer would then be able to negotiate for a better return rather than having their counterparty (who has no economic interest in preventing default) in that position.

What are your thoughts?

bob 4/22/2009  

Your are treating the 4.5% Convert SIX bonds as jr bonds and I believe that they are Sr. convertible bonds.

Hunter 4/22/2009  

Bob - I am going to read the indenture when I return to the office. Nonetheless, 15% going to the common and preferred...? Seems pretty rich given recent recoveries.

Anonymous,  4/22/2009  

The Six converts are senior notes which are pari with all the senior bonds..if a bond is a convert it is not always junior..you should read the indentures and learn who is a junior creditor
the deal that is out there gives 85% to the bonds and 10 or so to management and the remainder to the junior guys so you should also look at the deal after finding out what a junior creditor is

Hunter 4/22/2009  

Here is the link to the deal:

http://investors.sixflags.com/phoenix.zhtml?c=61629&p=irol-newsArticle&ID=1277807&highlight=

" If the Restructuring Plan is successful and all of the Holders of SFI Notes and holders of SFI Convertible Notes participate therein, the PIERS would be converted to approximately 10% of the outstanding Common Stock, the SFI Convertible Notes would be exchanged for approximately 26.7% of the outstanding Common Stock and the SFI Notes would be exchanged for approximately 58.3% of the outstanding Common Stock, with the existing holders of Common Stock holding approximately 5.0% of the outstanding Common Stock, in each case prior to taking into account the issuance of any equity under an equity incentive plan to be adopted in connection with the Restructuring Plan."

Erica Smith 5/07/2009  
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About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.