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Surprised that HN likes this article:) I'll start by laying out my biases and stating that I'm not a big fan of most PE firms. I think most people understand

Surprised that HN likes this article:) I'll start by laying out my biases and stating that I'm not a big fan of most PE firms. I think most people understand that CDS are a few things. 1) usually bespoke in that each one is different, ie these are contracts that you approach a bank to write for you and not fungible like a share. This means they are generally illiquid and usually don't pay out. 2) These used to be used, and still are, as insurance for bond holders. 3) as everyone how as seen or read the Big Short now knows, they started to be used by third parties to speculate on bankruptcies. 4) They pay out only when the agreed upon terms are triggered Blackstone, the PE firm holding the CDS's, is trying to get an otherwise healthy firm to "default" on some of their debt so that Blackstone can get the CDS payout. The problem is that the firm doesn't need to default so Blackstone is enticing them with better funding rates for their debt if they just do a "tiny bit of defaulting". Like I said, I don't really have alot of respect for PE firms. This is dirty. If this is allowed to happen then who in their right mind would ever again underwrite a CDS for a companies debt if some other company can so easily force a default event. I know that 2008 probably soured the term CDS for the average person but they are a very important part of the credit market and risk management. Just to be clear, the companies bonds are trading at or above par value, indicating that investors have confidence in the company’s ability to satisfy its debts as they come due.

whatok 9y ago
RE: 1, single name bespoke CDS are rarely traded nowadays especially given that more and more names are cleared now.
dogruck 9y ago
This sounds like a fairly obvious scenario that the lawyers who define the CDS would’ve considered. Is that true?
- dboreham 9y ago
  I was thinking the same thing, based on some discussion we had about a big contract we entered into that can terms where if we as the supplier got into financial difficulty, our customer could release our code from escrow and run it themselves. The concern was that the customer might deliberately try to push us into financial difficulty (e.g. by not paying us on time) as a way to in effect permanently avoid paying for our service. So our legal team added wording to the effect of "except if you caused it".
- yellowstuff 9y ago
  Nope! Blackstone has successfully done it before: https://www.bloomberg.com/view/articles/2013-12-05/blackstone-made-money-on-credit-default-swaps-with-this-one-weird-trick https://www.bloomberg.com/view/articles/2013-12-05/blackston...
  - dogruck 9y ago
    Thanks for the link. That article makes this intriguing point: “But you shouldn't overstate that value. The reason that Blackstone made money on its credit-default swaps is not just that they were triggered by this clever maneuver. Just triggering CDS is not a big deal, because CDS pay out based on the difference between the face value of a bond and its post-default trading value.” Is the same thing going on in this new deal?
    - whatok 9y ago
      All of the outstanding bonds except two of their smaller issues are being quoted above/close to par. CDS has not been triggered yet so can't really say but around those prices BX would probably lose money.
tome 9y ago
I've always been so puzzled by these "synthetic" financial products. If someone wants to "insure" a corporate bond, why don't they just swap it with a bank for a cash flow stream guaranteed by the bank, minus some premium?
- Godel_unicode 9y ago
  ... which guarantee would then be hedged by the bank with a CDS.
  - tome 9y ago
    Who would take the other side of that trade ... ?
- jeffwass 9y ago
  That's basically the same thing as selling the corporate bond and buying a government bond of similar maturity and coupon frequency in the same currency. Though I don't get why you're puzzled on synthetic derivatives, since what you've proposed is a synthetic instrument itself. It's an exchange of upfront payment for an annuity stream. And it's basically the opposite sign of the off-market swaps people in this HN community have already criticised banks for providing as a means of off-balance-sheet funding to some clients. (Eg, Greece and Italy entering into off-market swaps with banks, which is what your proposed contract is, except receiving upfront cash in exchange for the liability of a stream of future payments). Separately, the bank could wrap your annuity stream as into structured note to make it seem more like a cash bond. But then you're back into something even more bespoke and financially complex than a standard contract CDS.
- chollida1 9y ago
  > I've always been so puzzled by these "synthetic" financial products. Well what you are describing with your swap scenario is the very definition of a synthetic product, so your question as posed doesn't really make any sense:) The real answer probably has a few reasons 1) There are more benefits to owing a bond than just the coupon and principle payments, why give those up by handing ownership of the bond to the bank? With a CDS you still own the bond and the insurance in the case of a default, and remember a default doesn't mean the bonds go to zero. What if the bond doesn't default but goes way up in value, you've handed that value over to the bank rather than getting it yourself. What if you want to sell the bond before the expiry date. All of these are answerable on their own but you can see how this actually rapidly complicates things. 2) and this is probably alot more important, What if I don't have the bond itself but still want default insurance on the bond? I might be a large counterpart to the company, htey could be my largest client or supplier.
vostok 9y ago
The credit event auction means that you can't just get someone to write a CDS, create a default, and collect money. If everything is trading at par then the auction will be at 100 and you'll get nothing. The trick here is that they have bonds that are trading way below par. Honestly this seems like a story about someone falling asleep at the wheel.
- whatok 9y ago
  Below link has a primer on auctions as well as results: http://www.creditfixings.com/CreditEventAuctions/fixings.jsp http://www.creditfixings.com/CreditEventAuctions/fixings.jsp
- jessaustin 9y ago
  Is the implication that Goldman should have bought up those bonds until the price was higher, to protect their position? Do other sellers of these securities do the same? In that case, this would seem to be yet another example of Goldman seeking profit outside the game of finance. It worked for them in 2008...
  - vostok 9y ago
    It means that the level where they trade the CDS should account for this. TBAs are another good example where this stuff is important.
    - kchoudhu 9y ago
      As in passthrough TBAs? How so?
      - vostok 9y ago
        It's literally the same effect. The exact security isn't specified so you're going to get the "worst" one that is eligible. If you misjudge how bad the "worst" security is then you'll get screwed. Similarly, these CDS don't specify the exact security so you need to think about the worst case. The major difference is that the auction only happens if there is a credit event. Maybe here's an easy non-financial way to think about it. Suppose we sign a contract that says that I need to delivery 1 ton of at least 90% gold to you. When you price the contract, you probably shouldn't assume that I'll deliver 99% gold.
ww520 9y ago
That's an interesting analysis. Isn't that same as burning down one's house to get insurance payout? In this case, burn down a 3rd party's house or entice the 3rd party to burn down their own house.
- josu 9y ago
  Yes, that's exactly why you can't insure a 3rd party's house or life.
  - klipt 9y ago
    I guess insurance is more regulated. But maybe you can get a CDS on someone's house burning down?
    - kchoudhu 9y ago
      Mortgage default swaps (and other asset backed default swaps) are exactly this.
  - jessaustin 9y ago
    All life insurance is in a sense third-party?
    - deleted 9y ago
      [deleted]
  - leonroy 9y ago
    Employer's can take out life insurance on an employee (provided consent is given). Wondering if there are exceptions to this rule?
    - Kalium 9y ago
      I think it's about not creating adverse interests. Generally, a company is much more interested in a living employee than they are the payout from one dying.
jessaustin 9y ago
If this is allowed to happen then who in their right mind would ever again underwrite a CDS for a companies debt if some other company can so easily force a default event. Would this be terrible?
- chollida1 9y ago
  Yes, incredibly. CDS's are a form of insurance. It can be hard for someone not in the industry to see the importance of these as it doesn't affect yoru day to day life. Just imagine your day to day life where you can't get any isurance at all. No car insurance, no house insurance, no medical insurance. That's the extreme case, in all likely hood the more likely scenario would be all your insurance tripling in price as no provider can hedge their risk vai reinsurance, etc. To me issuance is very important and one of the pillars of modern society. If insurance going away, or atleast being inaccessible to 99% of the population that doesn't seem to be "terrible" to you then I'm not sure what explanation I can give you to help you understand :)
  - buxtehude 9y ago
    If CDS market disappeared or dried up - the broader insurance market will survive and exist just as it had prior to 1994 when the first CDS arrived.
  - JackFr 9y ago
    Credit default swaps were invented in 1994. Liquid bond markets existed for centuries without them (1602 for the Amsterdam Bourse and the late middle ages for the Italian city-states). CDS's are a form of insurance -- that's true. But in the case of a regular property/casualty insurance, you can't typically insure something you have no financial interest in. For CDS's, that's the base case. It is claimed that CDS's originally were created to allow investors to insulate themselves against the economic shock of defaults. That's barely true. CDS's are, and have always been, instruments of leverage (gearing). They allow credit traders to earn a higher return by taking on the credit risk with a smaller outlay of capital. I certainly don't want them to go away, but let's not kid ourselves that 1) they are fundamental to the credit market, or 2) they're not subject to potential abuse.
Enzolangellotti 9y ago
I still don't understand your objection to GSO's opportunistic trading. Triggers and credit events were provisions agreed on by both parties - it's a bespoke CDS after all - the only unintended consequence would be for future CPs to read the annexes to what they are trading, can't say it will be bad.

whatok 9y ago

RE: 1, single name bespoke CDS are rarely traded nowadays especially given that more and more names are cleared now.

dogruck 9y ago

This sounds like a fairly obvious scenario that the lawyers who define the CDS would’ve considered. Is that true?

dboreham 9y ago
I was thinking the same thing, based on some discussion we had about a big contract we entered into that can terms where if we as the supplier got into financial difficulty, our customer could release our code from escrow and run it themselves. The concern was that the customer might deliberately try to push us into financial difficulty (e.g. by not paying us on time) as a way to in effect permanently avoid paying for our service. So our legal team added wording to the effect of "except if you caused it".
yellowstuff 9y ago
Nope! Blackstone has successfully done it before: https://www.bloomberg.com/view/articles/2013-12-05/blackstone-made-money-on-credit-default-swaps-with-this-one-weird-trick https://www.bloomberg.com/view/articles/2013-12-05/blackston...
- dogruck 9y ago
  Thanks for the link. That article makes this intriguing point: “But you shouldn't overstate that value. The reason that Blackstone made money on its credit-default swaps is not just that they were triggered by this clever maneuver. Just triggering CDS is not a big deal, because CDS pay out based on the difference between the face value of a bond and its post-default trading value.” Is the same thing going on in this new deal?
  - whatok 9y ago
    All of the outstanding bonds except two of their smaller issues are being quoted above/close to par. CDS has not been triggered yet so can't really say but around those prices BX would probably lose money.

tome 9y ago

I've always been so puzzled by these "synthetic" financial products. If someone wants to "insure" a corporate bond, why don't they just swap it with a bank for a cash flow stream guaranteed by the bank, minus some premium?

Godel_unicode 9y ago
... which guarantee would then be hedged by the bank with a CDS.
- tome 9y ago
  Who would take the other side of that trade ... ?
jeffwass 9y ago
That's basically the same thing as selling the corporate bond and buying a government bond of similar maturity and coupon frequency in the same currency. Though I don't get why you're puzzled on synthetic derivatives, since what you've proposed is a synthetic instrument itself. It's an exchange of upfront payment for an annuity stream. And it's basically the opposite sign of the off-market swaps people in this HN community have already criticised banks for providing as a means of off-balance-sheet funding to some clients. (Eg, Greece and Italy entering into off-market swaps with banks, which is what your proposed contract is, except receiving upfront cash in exchange for the liability of a stream of future payments). Separately, the bank could wrap your annuity stream as into structured note to make it seem more like a cash bond. But then you're back into something even more bespoke and financially complex than a standard contract CDS.
chollida1 9y ago
> I've always been so puzzled by these "synthetic" financial products. Well what you are describing with your swap scenario is the very definition of a synthetic product, so your question as posed doesn't really make any sense:) The real answer probably has a few reasons 1) There are more benefits to owing a bond than just the coupon and principle payments, why give those up by handing ownership of the bond to the bank? With a CDS you still own the bond and the insurance in the case of a default, and remember a default doesn't mean the bonds go to zero. What if the bond doesn't default but goes way up in value, you've handed that value over to the bank rather than getting it yourself. What if you want to sell the bond before the expiry date. All of these are answerable on their own but you can see how this actually rapidly complicates things. 2) and this is probably alot more important, What if I don't have the bond itself but still want default insurance on the bond? I might be a large counterpart to the company, htey could be my largest client or supplier.

vostok 9y ago

The credit event auction means that you can't just get someone to write a CDS, create a default, and collect money. If everything is trading at par then the auction will be at 100 and you'll get nothing. The trick here is that they have bonds that are trading way below par. Honestly this seems like a story about someone falling asleep at the wheel.

whatok 9y ago
Below link has a primer on auctions as well as results: http://www.creditfixings.com/CreditEventAuctions/fixings.jsp http://www.creditfixings.com/CreditEventAuctions/fixings.jsp
jessaustin 9y ago
Is the implication that Goldman should have bought up those bonds until the price was higher, to protect their position? Do other sellers of these securities do the same? In that case, this would seem to be yet another example of Goldman seeking profit outside the game of finance. It worked for them in 2008...
- vostok 9y ago
  It means that the level where they trade the CDS should account for this. TBAs are another good example where this stuff is important.
  - kchoudhu 9y ago
    As in passthrough TBAs? How so?
    - vostok 9y ago
      It's literally the same effect. The exact security isn't specified so you're going to get the "worst" one that is eligible. If you misjudge how bad the "worst" security is then you'll get screwed. Similarly, these CDS don't specify the exact security so you need to think about the worst case. The major difference is that the auction only happens if there is a credit event. Maybe here's an easy non-financial way to think about it. Suppose we sign a contract that says that I need to delivery 1 ton of at least 90% gold to you. When you price the contract, you probably shouldn't assume that I'll deliver 99% gold.

ww520 9y ago

That's an interesting analysis. Isn't that same as burning down one's house to get insurance payout? In this case, burn down a 3rd party's house or entice the 3rd party to burn down their own house.

josu 9y ago
Yes, that's exactly why you can't insure a 3rd party's house or life.
- klipt 9y ago
  I guess insurance is more regulated. But maybe you can get a CDS on someone's house burning down?
  - kchoudhu 9y ago
    Mortgage default swaps (and other asset backed default swaps) are exactly this.
- jessaustin 9y ago
  All life insurance is in a sense third-party?
  - deleted 9y ago
    [deleted]
- leonroy 9y ago
  Employer's can take out life insurance on an employee (provided consent is given). Wondering if there are exceptions to this rule?
  - Kalium 9y ago
    I think it's about not creating adverse interests. Generally, a company is much more interested in a living employee than they are the payout from one dying.

jessaustin 9y ago

If this is allowed to happen then who in their right mind would ever again underwrite a CDS for a companies debt if some other company can so easily force a default event. Would this be terrible?

chollida1 9y ago
Yes, incredibly. CDS's are a form of insurance. It can be hard for someone not in the industry to see the importance of these as it doesn't affect yoru day to day life. Just imagine your day to day life where you can't get any isurance at all. No car insurance, no house insurance, no medical insurance. That's the extreme case, in all likely hood the more likely scenario would be all your insurance tripling in price as no provider can hedge their risk vai reinsurance, etc. To me issuance is very important and one of the pillars of modern society. If insurance going away, or atleast being inaccessible to 99% of the population that doesn't seem to be "terrible" to you then I'm not sure what explanation I can give you to help you understand :)
- buxtehude 9y ago
  If CDS market disappeared or dried up - the broader insurance market will survive and exist just as it had prior to 1994 when the first CDS arrived.
- JackFr 9y ago
  Credit default swaps were invented in 1994. Liquid bond markets existed for centuries without them (1602 for the Amsterdam Bourse and the late middle ages for the Italian city-states). CDS's are a form of insurance -- that's true. But in the case of a regular property/casualty insurance, you can't typically insure something you have no financial interest in. For CDS's, that's the base case. It is claimed that CDS's originally were created to allow investors to insulate themselves against the economic shock of defaults. That's barely true. CDS's are, and have always been, instruments of leverage (gearing). They allow credit traders to earn a higher return by taking on the credit risk with a smaller outlay of capital. I certainly don't want them to go away, but let's not kid ourselves that 1) they are fundamental to the credit market, or 2) they're not subject to potential abuse.

Enzolangellotti 9y ago

I still don't understand your objection to GSO's opportunistic trading. Triggers and credit events were provisions agreed on by both parties - it's a bespoke CDS after all - the only unintended consequence would be for future CPs to read the annexes to what they are trading, can't say it will be bad.