As delegates to the annual general meeting of the International Swaps and Derivatives Association (ISDA) gathered in Miami on the evening of April 24, they had a surprise regulatory intervention in a trading dispute to digest.
The Commodity Futures Trading Commission (CFTC) announced that it is examining whether manufactured credit events designed to trigger default swaps constitute market manipulation, a few hours before ISDA delegates gathered at a reception by the pool in the Delano hotel in South Beach, and the implications of this action quickly became a main point of conversation.
“The statement came as a surprise – first because it was forceful, but also because the CFTC has not said much about the credit default swap (CDS) market before, but I think they will need to come out with more guidance than a press release,” said Fabien Carruzzo, a partner and head of the derivatives and structured product group at law firm Kramer Levin.
Opponents of Blackstone’s trading tactics designed to profit from default swaps it bought on homebuilding firm Hovnanian were understandably keen to frame the regulatory intervention as backing for their case.
“It is clear that the CFTC are putting down a marker,” said Bob Pickel, a former ISDA CEO who recently acted as an expert witness on behalf of hedge fund Solus, which is suing Blackstone’s GSO unit over the trades. “It is a strong assertion of their authority in the area and that possible manipulation may be involved.
“Solus is alleging fraud and manipulation, so it has to strengthen their case that one of the two regulators is making that statement.”
David and Goliath
Solus is a relatively obscure fund that can seem like David to Blackstone’s Goliath in the conflict over Hovnanian default swaps.
Solus has around $6 billion in assets, so it is dwarfed by Blackstone, which had $450 billion under management at the end of March 2018, with $140 billion of assets in its credit fund GSO alone.
Solus in January lost a legal attempt to slow down the exercise of default swaps on Hovnanian bonds that have been engineered by GSO to increase its derivatives payout from a credit event.
GSO accordingly seemed to be home and dry on a complex trade that could deliver profit of as much as $230 million on its roughly $330 million holding of default swap protection, assuming that it can deliver specially created bonds for swap exercise that are trading at levels of a little over 30 cents in the dollar.
But the CFTC’s intervention – exactly a week before a planned failure to pay an interest payment due on Tuesday was scheduled to set the Hovnanian default swap process in motion – has dramatically raised Blackstone’s reputational risk surrounding the controversial deal.
It also increases the likelihood that Blackstone’s trading tactics will become a point of conflict between the asset manager and some notable Wall Street dealers, including Goldman Sachs.
GSO is unlikely to have bought much of its $330 million of Hovnanian default swap protection directly from Solus, even though the $260 million of derivatives exposure sold by Solus is the reason for its legal battle to delay an engineered default by the homebuilding firm.
The CFTC has been tightlipped about why it decided to intervene in the dispute
Both funds are instead likely to have conducted their trades with dealers at banks, with their intermediaries then offsetting risk to leave their books roughly flat – at least under normal circumstances.
Goldman Sachs and some other dealers are instead believed in the marketplace to be net sellers of Hovnanian default swap protection, which would leave them exposed to potential losses from Blackstone’s trading tactics.
That in turn raises the possibility that dealers put behind-the-scenes pressure on the CFTC to back their view that Blackstone’s trade constitutes market manipulation.
The CFTC has been tightlipped about why it decided to intervene in the dispute.
Its chairman Christopher Giancarlo attended the ISDA AGM, but after teasing delegates with the statement about potential default swap manipulation, he then focused on what he described as a “software upgrade” for broader derivatives regulation in his only public remarks.
When Euromoney asked Giancarlo if Goldman Sachs had lobbied for a regulatory statement about potential CDS manipulation, he declined to comment about any aspect of the CFTC release.
Goldman Sachs said it does not discuss its interactions with regulators.
Many delegates at the ISDA AGM were nevertheless convinced that lobbying from Goldman or other dealers was more likely to have had an effect on the CFTC’s thinking than a plea for regulatory assistance from Solus.
They noted that the CFTC made extensive reference to a statement by ISDA’s board earlier in April that said what it described as “narrowly tailored credit events” could threaten the efficiency, reliability and fairness of the CDS markets.
The CFTC’s own release used more strident language than the ISDA board statement, by defining trading tactics such as those deployed for Hovnanian default swaps as “manufactured credit events” and saying that they might constitute market manipulation and “severely damage” the integrity of the CDS markets.
The CFTC noted that this could affect the market for CDS index products in a nod towards its uneasy role as a co-regulator of the credit derivatives markets in the US, where it shares responsibility for supervision with the SEC.
In one of the many quirks of the fractured US financial regulatory system, the SEC is responsible for single-name CDS supervision, while the CFTC regulates default swap indices, which are baskets of default swaps.
A move towards joint regulation of single-name swaps is widely expected, but if the CFTC is perceived to be forcing the hand of the SEC over the issue of whether default swap exercises on Hovnanian constitute market manipulation, then historical tensions between the two regulators could resurface.
And if Goldman did press the CFTC to act – effectively dropping a dime on Blackstone, to use the old slang phrase for making a phone call to authorities to turn in a criminal – then relations between two of the biggest players on Wall Street could also take a turn for the worse.
The Hovnanian swap issue was reportedly among topics in a recent meeting between Goldman Sachs CEO Lloyd Blankfein and Jon Gray, the recently appointed president of Blackstone and heir apparent to CEO Stephen Schwarzman.
It could also become contentious within Goldman, as bankers who seek business from Blackstone’s private equity and real-estate divisions would be unlikely to welcome escalation of a dispute between their own firm’s fixed income traders and Blackstone’s GSO credit unit.
GSO has appeared to stay a step ahead of its opponents in the Hovnanian debt battle. A recent move to increase the supply of Hovnanian bonds priced at a deep discount was widely seen as an effective way to head off the potential that default swap protection sellers could push up the prices of existing bonds to lower their eventual derivatives payouts, for example.
But dealers could try to delay the formal recognition of a default event by ISDA’s credit derivatives determination committee even after a month’s grace period has elapsed after a May 1 failure to pay interest on a nominal amount of Hovnanian debt.
That would leave time for the CFTC or the SEC to turn up the regulatory heat on Blackstone for its aggressive tactics and spoil what looks like a perfect trade.