The Rise of Empty Creditors?

Bankruptcy investing and distressed debt investing is a difficult and complicated process. Creditors and debtors usually have different motivations for their actions. Different creditors have different motivations for their actions. Some creditors like to take back equity to gain control of the company; others (like CLOs) want reinstated debt. Other want the company to be liquidated and to receive a fat dividend. Debtors generally want to stay alive. If management can hang onto their seats, they can be granted cheap options on the reorganized stock at the expense of other creditors. I have seen very few cases where a management walks into the court and says - "Judge, I want to liquidate." It just does not happen.

In summary - always, always look to incentives of various stakeholders.

Daniel Gross penned an interesting piece for Newsweek entitled "The Rise of the 'Empty' Creditor" Generally he brings up some fair points, unfortunately I have to disagree with him on a few others.

For those that are experienced in the CDS market, please skip this paragraph. From those that do not play in the CDS market on a regular basis, there are certain trades investors put on to exploit perceived mispricings in the market. One of these trades is a basis trade. Now there are many different flavors of basis trades, but for this post, I am focusing on one in particular. In essence, one buys credit protection, as well as the underlying bond to capture a point or yield spread in the underlying entity. For example, at one point in the not too distant future, you could buy Neiman Marcus bonds at 60 cents on the dollar, but credit protection at 25 points up front and capture a positive spread (i.e. the bonds were paying a higher coupon then the CDS insurance carry). In essence, if Neiman Marcus filed tomorrow, I should make money on that trade.

Why? If the CDS auction goes off at 30 points (meaning, those who sold protection owe 30 points to the buyers of protection), the bonds theoretically should be worth 70 points (CDS Points Up Front + Bond Price should equal 100). I make money two ways on that trade. 1. My bonds move up 10 points and 2. My CDS widened another 5 points.

Now the next question you are going to ask is: why doesn't everyone do this? Well, a lot of people do this trade - unfortunately, the market gets wacky sometimes. Especially in the illiquidity that is distressed debt securities. You can lose billions and billions of dollars (on a mark to market basis) like Deutsche Bank did last year.

In the example above, I am indeed preserving my economic interest in hope the company to fail. More importantly - I am preserving my investors economic interest. Do I not have a fiduciary duty as an investor to generate the highest risk adjusted return for my investors?

The main point I take difference with in Daniel Gross' article is his take on Six Flags. We profiled Six Flags' debt in an earlier post. I completely disagree with his notion that bond holders (like Fidelity Investments) accept the tender offer. In the tender, bond holders are only to receive 58.3% of the new stock. Who cares if they have an offsetting CDS position - as they are splitting the rest of the post restructured equity with the converts and then giving the rest to the junior claimants, who should get nothing more than warrants at best. In reality, do you really think the common or preferred'd deserve anything? If I were Fidelity, I would hold out as well until a better exchange was offered.

And the reason GGP filed was because it was massively overlevered. Not because of the CDS market. Abitibi filed because its a asset heavy, cyclical company in a secularly decling business - these businesses file for bankruptcy in times like this. And when they come out of bankruptcy, with a cleaner balance sheet, in a better economy, creditors who saw a value proposition buying their debt on the cheap in or out of bankruptcy make money.

For whatever reason, the press always seems to shift the blame to hedge funds. Why not blame GGP's former CFO and CEO for levering up at the top? Why not blame Six Flag's former management for spending over a billion dollars on capex in the last 8 or so years with -95% return to shareholders. Hedge funds don't make companies go bankrupt - poor management, poor corporate governance, and poor financial policies make companies go bankrupt.