The top US regulator of the derivatives market has opened a new front in a battle over so-called intentional defaults that has dented confidence in the credit default swap market.
In a strongly worded statement, the Commodity Futures Trading Commission on Tuesday said intentional defaults, which are not tied to a company’s financial health, could amount to “market manipulation” and “severely damage” the CDS market.
The statement came as hundreds of market participants gathered in Miami for the annual meeting of the International Swaps and Derivatives Association and occupied many of the side conversations at the three-day event.
“It is significant because if manufactured defaults were to happen left, right and centre, that could cause a collapse of confidence in the credit derivative market,” Simon Firth, a partner at Linklaters, told IFR.
Several attendees said they welcomed the CFTC’s decision to step into the fray, which stems from a controversial arrangement in which US homebuilder Hovnanian agreed to default on some of its debt in exchange for a low-cost loan.
The loan was provided by Blackstone’s credit arm GSO, which stands to receive a large payout once the default occurs, having bought more than US$300m of CDS protection referencing Hovnanian.
Hedge fund Solus, which sits on the opposite side of the CDS trade, has sued for damages, alleging the deal amounts to fraud and arguing that it perverts the functioning of the CDS market.
Blackstone is buying a 55% stake in the Thomson Reuters F&R division, which includes IFR.
FISHY BUSINESS
Some legal experts say the CFTC’s statement could act - at the very least - as a deterrent to the proliferation of other engineered defaults.
“The CFTC is saying: ‘This seems fishy to me’,” one derivatives lawyer told IFR.
“They are signalling to the market that they are taking an interest in finding out more about manufactured credit events and possibly looking at them as a form of market manipulation.”
In the statement, the CFTC said that in instances of manufactured credit events, its divisions “will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS”.
These actions, lawyers said, could range from requesting additional information about a specific transaction to enforcement actions against the parties involved if the agency determines that manipulation or fraud took place.
“Regardless of the words on the page [in the CDS contracts], they can say this is not how the market is supposed to work,” said Robin Powers, a partner at Rimon.
CFTC chairman Christopher Giancarlo told IFR on Thursday his agency has been coordinating with the Securities and Exchange Commission as it looks into the issue of manufactured credit events. The CFTC regulates CDS indices, while the SEC has authority over single-name CDS.
Representatives for Hovnanian, GSO and Solus declined to comment on whether the two agencies had made inquiries about the controversial deal.
“[Hovnanian] is confident that it has acted properly at all times related to its financing transactions with GSO,” a spokesman for the New Jersey-based homebuilder told IFR.
“Our policy is to cooperate fully with all requests by regulators.”
DOCUMENT CHANGES
Critics of the Hovnanian deal have been pushing for ISDA to amend the terms of its standard derivatives contracts to prevent the proliferation of similar cases in the future.
Earlier this month, ISDA’s board of directors ordered consultations on possible changes to the documents.
Speaking with reporters on the sidelines of the conference, ISDA’s chief executive Scott O’Malia said the CFTC statement was a welcome development to the discussion his organisation and market participants are having about potential changes.
“This really puts the spotlight on it,” O’Malia said.
“It will be useful in terms of having that discussion … and as the board indicates in its statement, we are committed to doing that. We have to let that process run and at the end of the day hopefully we get some good reforms.”
Lawyers have said a number of approaches are possible, including linking a credit event to a deterioration in the financial profile of the company or raising the default threshold required to trigger a credit event.
As part of the deal with GSO, Hovnanian has agreed to miss only a small payment it owes to one of its subsidiaries to trigger payments on its CDS. It was not at risk of immediate default when it agreed to the deal.
The lawyers cautioned, however, that a definitive solution to manufactured credit events may be hard to come by, as the committees charged with determining whether a default has occurred cannot take a view on the “intention” behind a default.
“The market is not always able, just through objective tests, to plan for anything that can happen,” said Powers.
“Regulators can look past the objective transactions and make sure the market remains fair for all the players.”
