United States: CDS Market Integrity After Hovnanian

In a companion piece, we reviewed the recent federal district court decision in Solus Alternative Asset Management LP v. GSO Capital Partners L.P. (SDNY Jan. 29, 2018). In its ruling, the court declined to block a financial restructuring proposed by Hovnanian Enterprises, Inc., which relied in part on an engineered credit event that would trigger payment under credit default swap (CDS) contracts referencing Hovnanian. By agreeing to engineer the credit event, Hovnanian anticipated receiving favorable financing terms from GSO Capital Partners LP, a purchaser of credit protection. The transaction was challenged by Solus Alternative Asset Management LP, a seller of credit protection that would be required pay out on its CDS contracts if a credit event were determined to have occurred. Among the rationales advanced by Solus in support of its request for an injunction was the threat to the integrity of the CDS market if the Hovnanian transaction were permitted to go forward.

Hovnanian is another link in the evolution of CDS contracts from a pure hedging or bespoke investment product to an opportunistic, stand-alone investment strategy. Historically, CDS tied into restructuring conversations as an inhibiting factor to debtholders negotiating on equal footing. In that context, the CDS market can provide an economic incentive for CDS protection buyers holding obligations of the reference entity to negotiate in a refinancing (e.g., by breaking basis trades). In the newer model of CDS as an opportunistic investment, the CDS market is being used affirmatively as a source of capital for participating debtholders to supplement a refinancing package and thereby allow for more favorable terms to the issuer.

This new restructuring technique, of course, rests on the backs of the CDS protections sellers, and Solus, as a protection seller, was unwilling to play along. Solus in effect argued that the proliferation of engineered failure-to-pay credit events risks damaging the CDS market to the point of collapse. In support of this thesis, Solus' expert witness opined that CDS contracts become impossible to price where credit events can be engineered, CDS contracts would cease to serve their beneficial risk-spreading function and consequently, liquidity in the CDS market would dissipate. Solus further argued that ISDA, whose rules and procedures govern the CDS market, was incapable of protecting the markets against the adverse consequences of engineered credit events. The court, at least on a preliminary injunction motion, declined to enter this thicket. 

Analyzing the Solus Argument: Pricing and Liquidity

GSO's expert argued against the Solus position. Engineered defaults, he observed, have been around for some time now — at least since the Codere episode in 2013 — and they have not yet threatened, and likely will not threaten, the viability of the CDS market. The reason is that the market is capable of embedding additional premium into pricing to reflect the risk of engineered, opportunistic credit events. Moreover, the enhanced risk/reward opportunities have attracted new participants that, to the contrary, have increased market depth.

  • Pricing

Pricing of a CDS contract reflects (i) the probability that a failure to pay will occur with respect to the reference entity and (ii) the likely value of the CDS contract in the event a failure to pay does occur. The probability of default must now factor in the possibility that a reference entity will pursue a strategy involving an engineered default. Numerous factors enter into this assessment — cross-default thresholds, acceleration terms, other provisions of the underlying debt, the financial condition of the reference entity, and its short- and long-term capital requirements, among others. According to the GSO buy-side position, there appears no reason why the prospects for an engineered credit event cannot be modeled and priced. In addition, the highly specific fact pattern required to make a particular reference entity an attractive candidate for such strategies limits the universe and can generally be identified through publicly available information.

As discussed in the companion article, Hovnanian introduced into the pricing calculus a new feature that was absent in prior engineered credit events. Not only did Hovnanian commit to a failure to pay but it also agreed to issue a debt instrument that may trade below the market price for the issuer's existing debt obligations and, if so, would therefore be the cheapest to deliver upon the occurrence of a credit event. It would be this instrument that would primarily impact the payout under the CDS contracts on which Hovnanian was the reference issuer, at levels that would likely be higher than they would be in the absence of this new obligation.

The risk to a CDS protection seller that a reference issuer might issue additional, lower-priced obligations during the term of its CDS contract is not new. It is a risk that has been baked into the pricing for CDS contracts from the start (even though the impact on pricing was likely based on anticipated markets terms that could be achieved by an issuer and potential lenders negotiating on an arm's-length basis). The risk is also not wholly unquantifiable, even with the advent of obligations specifically engineered to be the cheapest to deliver on the occurrence of a credit event. To be viable, these engineered strategies require the auction at which the payout on the CDS contracts is established to land in a particular, and therefore somewhat predictable, range. So, the argument goes, CDS protection sellers should be able to assess the risk of the Hovnanian strategy on a particular name and price accordingly. As mentioned above, in many cases the availability of these strategies to a particular reference entity can be identified through diligence, and therefore these risks can be assessed with some degree of accuracy.

  • Liquidity

GSO's expert witness also attacked the specter conjured up by Solus of a frozen CDS market if engineered credit events were left unchecked. The expert observed that CDSs have evolved over the years from a pure hedging/default protection tool to an opportunity-seeking investment strategy. The influx of return-seeking market participants has deepened the CDS market and enhanced its liquidity. Multiplying the input variables for CDS contracts and increasing the uncertainty of outcome should enhance the attractiveness of the market to return-seeking investors.

The market reaction, more precisely the absence thereof, to the Codere and iHeart cases appears to support this thesis. The CDS market (at least right now) has been undeterred by the engineered credit events showcased in those two widely analyzed situations. Hovnanian similarly appears to have had minimal impact on the market, although its failure to pay will not occur until May 2018 and the analysis may change closer to that time as the market prices in losses.

No Calls for Change — Yet

The Solus "cries of wolf" are undermined by yet another indicator of market viability. Despite the proliferation of engineered strategies, both implemented and contemplated, there has been no groundswell of calls on ISDA to modify the form of CDS contract to eliminate perceived abuse. While it is clear that groups of market participants are discussing changes to the CDS contract, it is not clear that there is a critical mass on the horizon sufficient to drive ISDA to make such changes.

One reason that, to date, the CDS market has taken engineered credit events in stride is quantity. While there have been a few well-publicized engineered credit events, and others have been proposed, the actual number of cases in which engineered credit events have appeared has been relatively small, and the universe of possible cases appears also limited.

Another reason for silence in the broader market may be that all instances of engineered credit events thus far have involved financially distressed, albeit performing, entities. Codere was trading at distressed levels, and in the absence of the engineered failure to pay credit event, the company would likely have experienced near-term defaults. iHeart was, and remains, highly leveraged, and its active pursuit of a restructuring, now in a bankruptcy context,  indicates that its capital structure is unsustainable in the short-to-medium term. Similarly, Hovnanian is under financial pressure and at risk of a default absent a refinancing. The common thread in each of these situations is a credit event, albeit an unconventional one, driven by the ill health of the reference entity.

It remains to be seen how far these strategies may be pushed. At the current time, the market appears willing to live with, and price in, the possibility of unconventional credit events for entities in financial difficulty, even where the debt markets have yet to fully reflect the difficulty. However, the possibility exists that CDS protection buyers may seek to replicate their strategy with financially sound companies. That being said, the likelihood that a financially sound company would entertain such a strategy appears fairly low given that it would presumably have access to a number of much less complex financing alternatives not involving the relative uncertainty and risks implicated in unconventional credit events. Moreover, the ability to identify/create an obligation trading at a sufficient discount to par to make the unconventional credit event strategy economically viable is more difficult at a financially sound reference entity, particularly given the maximum maturity limitations in the Credit Derivatives Definitions.

If the strategy is adopted by an entity not in need of a financial restructuring, this may put sufficient pressure on ISDA and the community of protection sellers generally for them to draw a line in the sand. Monetizing CDS in support of a restructuring may bend the rules of the CDS model, but at least it remains in the realm of financial reorganization. Monetization of a CDS contract through the legerdemain of an engineered credit event without a capital structure under stress would cut CDS loose from its original moorings entirely. If such credit events were attempted, it is anyone's guess how the market would react, but a backlash could well reach Hovnanian-type deals as well.

Conclusion

The Hovnanian litigation is ongoing, and surprises may yet be in store there for unconventional failure-to-pay credit events in the CDS space. Notwithstanding the Solus arguments in that case, the CDS market currently shows few signs of disruption on account of engineered credit events involving financially distressed reference entities. That could change, however, if events of this nature were to proliferate to a level that threatens the ability of protection sellers to achieve risk-commensurate pricing. The extension of engineered credit events to financially sound reference entities, if this were to happen, would undoubtedly apply greater pressure on the CDS market. In these as yet uncharted waters, ISDA may be forced into modifications of the form CDS contract to ensure the continuing viability of the CDS market. However, at least for now, engineered credit events are simply part of the market and, in the right circumstances, are an innovative new source of refinancing capital.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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