Coal in some stockings, treats in others, but who’s been naughty and who’s been nice? In the world of big-time financial side bets (Credit Default Swaps), it isn’t exactly clear.
When I heard about the unusual happenings that kept Radio Shack open for at least one more Christmas season, my thoughts went to the decision process for the traders on each side of a massive CDS trade. Making money is the primary reason they play, but there is something else going on.
Senior people on Wall Street have their own version of Black Friday – the day after Thanksgiving that some retailers need to push their full year into the black. It’s not the same day at every Street firm or hedge fund, but it’s just as manic as the mall scenes with people trampling each other to get enormous televisions. On one day each year, everybody gets their “number” – their bonus for the year.
This year, as every year, people are trying their best to book big profits while the bosses are deciding who gets how much of the bonus pool.
From the glossary of Finance Monsters, here’s the definition of the Bonus Pool:
Bonus Pool – The money allocated to pay bonuses, the once-a-year paychecks that usually exceed the “base salary” of those on Wall Street, often by millions of dollars. Top producers often get 90% of their annual pay in a bonus check. Even clerks and administrative assistants can get six-figure bonuses, so “Bonus Day” is a yearly exercise in mass hysteria.
To me, it’s not just the fact that derivative bets 28 times larger than the debt at issue have now changed the course of the debt itself, it’s also a matter of timing. Both sides of the trade are driven by what we used to call “yield to bonus.” If the profit can be locked in between October and December, it tends to weigh more heavily in the minds of the people giving out the money to their traders.
So two sets of highly-paid hedge fund traders are on opposite sides of a massive trade. Nothing new there, though it’s more likely to have the hedge funds on one side and small towns in Norway or small cities in Massachusetts on the other side of the trade.
As the more detailed Bloomberg article by Jodi Xu Klein tells us, the credit bears in the trade were paying big bucks to bet against Radio Shack for relatively short time frames. One set of CDS contracts, for example, expired on December 20, and cost the bearish CDS buyer 36.5 cents on the dollar (up front) in September. Put into terms more like hedge funds use, that was $36.5 million dollars deposited for every $100 million face amount of CDS, with the payoff only if Radio Shack defaulted before December 20, 2014.
More time cost even more. It took a deposit of 53% to get insurance that was effective until March of 2015.
So let’s say that the hedge funds on the other side of the trade saw a way to deliver coal into the credit bear’s stockings by taking their money, and using some of it to make sure they lost. It wouldn’t be out of line to think the bigger funds mentioned each had $500 million or $1 billion in CDS outstanding.
So here’s how the numbers might work:
The “bulls” sell $2 billion in CDS good for six months in September of 2014, and collect $1.07 billion in cash, plus some insurance premiums along the way. The “bears” think their $1.07 billion (plus spare change paid in insurance premiums) will turn into $1.6 billion when Radio Shack defaults. They think that because they expect the “salvage value” of Radio Shack debt will only be 20 cents on the dollar when the company goes bankrupt.
We do know that the company got to stay in business when it got $585 million in funding in October, and the biggest shareholder in the common stock arranged that funding. The bulls, sitting on a billion+ dollars in my example, recognized that a couple of hundred million thrown toward the $275 million senior financing in the package ensured that they kept the money they had already collected from the bears. They definitely got to keep the money collected for December, 2014 CDS, and they’ve locked in the profits for next year’s CDS, assuming Radio Shack doesn’t default on its outstanding $841 million in bonds and loans before then.
As reported by Bloomberg’s Klein:
“As part of the October funding, DW Investment, run by David Warren, bought more than $100 million of a $275 million first-lien loan, the people with knowledge of the deal said this month. Saba, founded by former Deutsche Bank AG credit-trading head Boaz Weinstein, also bought a piece of the debt, they said. Both firms have swaps investments that would benefit from Radio Shack’s solvency, the people said.”
Who knows, maybe the hedge funds mentioned in the Bloomberg article actually have $5 billion out of the $25 billion in CDS side bets – there’s no way to tell.
And the story may not be over. When that $585 million in financing comes due, the owners of the senior $275 million note will be in a position to act as private equity investors in a majority position, stripping out any value there might be in store locations or leases (especially in a pre-packaged bankruptcy), plus the value of a well-established brand name for online commerce, or maybe by raiding an old-fashioned pension fund. After all, it is a 93-year-old company, ripe for “restructuring” and all the fees and profits that creates.
While these sellers of the CDS seem to have won (big time) for this year’s bonus, they may well have another good year next year.
The ironic thing, to me, about this story is that it provides a perfect counterpoint to another derivatives-driven trade that changed the course of the real world just in time for last year’s bonus madness (October, 2013). In that trade, the CDS buyers (the bears) were the ones who provided the company (Codere) a lifeline. That company was able to get its loan, but only if it deliberately paid interest two days’ late, triggering a default that made the CDS contracts pay off.
So I guess the question who is naughty and who is nice is still open for debate.