Blackstone’s ‘rigged’ debt exchange might be a restructuring too far for CDS market

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As GSO’s controversial Hovnanian refinancing ends up in court, the wider credit default swap (CDS) market is the loser.

When is a credit event not a credit event? That eternal question was approached from an unusual angle by New Jersey-based building firm Hovnanian at the end of last year when it agreed to intentionally default on some of its debt in return for fresh financing.

The move provoked uproar in the market with the slightly surreal sight of Goldman Sachs and a large US hedge fund entreating those in the CDS market to play fair and stick to the rules.

The dispute stems from a debt restructuring scheme put forward by GSO, part of the Blackstone Group. GSO has offered to refinance Hovnanian’s outstanding $1.6 billion debt load through an exchange: swapping its existing 8% 2019 bonds for a combination of cash and bonds maturing in 2026 and 2040.

The latter 22-year bond offers a coupon of just 5% – for a credit that is theoretically rated triple C minus. More of that later.

Some $26 million of the 8% bonds involved in the exchange will, however, be bought back by a Hovnanian affiliate. The plan is to miss an interest payment on these bonds, which will effectively be the firm defaulting on itself, but will trigger the Hovnanian CDS.

This is when that 22-year bond comes into its own: it carries such a low coupon that it is expected to trade at a massive discount to par and will therefore offer a lucrative payout to CDS protection holders when the CDS are triggered.

And who are those protection holders? Why, GSO itself.

This is the deal: GSO will extend favourable refinancing terms to Hovnanian in return for giving itself a nice little payday by triggering the CDS. This is not the first time that GSO has put forward such a plan: it did the same in 2013 for Spanish gaming company Codere, providing refinancing in return for the distressed company missing an interest payment on its bonds and triggering its CDS.

Outraged

So everyone is happy, right? Well, not the protection sellers. In Hovnanian’s case this includes Goldman Sachs, which is understood to have sold up to $200 million CDS protection on Hovnanian.

“We fear that the Hovnanian situation … would undermine the true intention and spirit of the CDS market,” declared the US bank’s outraged head of distressed debt trading.

It is understood to have partnered with another burned CDS seller, Solus Alternative Asset Management, to offer an alternative refinancing plan – a single 9.3% note, which is the weighted average coupon of the existing 13.5% and 5% notes. Solus is now suing GSO together with Hovnanian’s chief executive officer and chief financial officer over the proposed deal, describing the 22-year note as a “rigged bond”.

It states: “The intended effect of Hovnanian’s complicity in GSO’s scheme 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.”

The first hearing in the case was set for Thursday.

The CDS market has struggled to rehabilitate itself since the financial crisis and situations such as this hardly help. Few sights elicit less sympathy than CDS traders climbing on high horses about market integrity.

GSO’s Hovnanian refinancing might be clever, but it certainly feels wrong. Regardless of the outcome of the case, the publicity that it has attracted shows no one in a good light.

It will also encourage yet closer regulatory scrutiny of a market that is already held under deep suspicion. GSO’s Codere deal ended up on The Daily Show with Jon Stewart in 2013. The CDS market should now brace itself for more of the same.