CDSs/SEC: easier to spotlight wheezes than stop them
Legal threat will probably have intended chilling effect on the most aggressive hedge funds
The distressed debt markets have resembled the Wild West in recent years. Free-wheeling hedge funds, not content with buying beaten-down bonds and loans, have turned to derivatives to amp up wagers. Some appear to have used credit default swaps — conceived originally as hedging tools for debtholders — to force companies to file for bankruptcy, or avoid doing so. This generated big gains or losses for CDS investors.
There is no new sheriff in town. But the old one is polishing up its badge before higher rates and tapering state support cause problems. The Securities and Exchange Commission last month proposed sweeping new rules to force the public disclosure of large CDS positions. These would also make CDS investors subject to the existing anti-fraud provisions of US securities law.
The disclosure requirements look sensible. The anti-fraud rider looks more like hand-waving. Odious though some CDS transactions may appear, very few look anything like market manipulation. But the mere introduction of a legal threat will probably have the intended chilling effect on the most creative and aggressive hedge funds.
In two high-profile CDS cases — involving Europe’s Codere SA and Hovnanian of the US — hedge funds with credit derivative bets fought to give weak companies better rescue financings. In return, the companies were meant to default, or avoid it, at specific dates.
In another case, US telecoms group Windstream was forced to file for bankruptcy when hedge fund Aurelius Capital successfully argued in court that a reorganisation had been improper. The hedge fund, which held CDSs, then seemingly won a windfall. How much is unclear, given the lack of disclosure the SEC seeks to fix.
Other regulators have previously frowned upon hedge fund manoeuvres involving CDSs. Bad headlines have made hedge funds more wary of appearing opportunistic and greedy. Company failures have a human as well as a financial dimension.
The SEC’s efforts to shine a light on swap transactions is wise. Enforcement actions will however be trickier to pull off than the moneymaking wheezes they aim to police.