Render Unto Caesar’s, but Where?

And to Whom?

$26.9 billion in CDS muddy the waters in Caesar’s Casino’s $18.4 billion in debt restructuring.

With two main classes of debt, the senior bondholders have agreed to terms and filed Chapter 11 together with the private equity owners of the company in bankruptcy court in Chicago. But holders of the junior debt are suing, and also filed for Chapter 11 bankruptcy, but in Delaware.

And then there’s the Credit Default Swap (CDS) position, roughly one and a half times the size of the debt issues.

The junior debt holders didn’t get their interest payment in December, a deferral the company points out is allowed in the subordinated bond offering documents. Still, the holders of the much larger CDS position went to the International Swap Dealers’ Association (ISDA) to ask for a payoff. In the parlance of the Association, they wanted the missed payment declared a “credit event.”

On January 6, ISDA announced the non-results of its Determination Committee regarding Caesar’s Entertainment. Only five of the fifteen voting members of the Committee voted “yes,” so a Credit Default Swap payout was not triggered, but since it takes twelve votes to dismiss the claim, it isn’t over yet.

Without sufficient votes either way at ISDA’s Determination Committee, the matter was sent on to an arbitration panel of three independent professionals.

Two members of the Committee who voted to trigger the CDS credit event were Goldman Sachs and Elliot Management Corp.

Regarding one of the voting members of the CDS credit event Determination Committee, Bloomberg reported the following:

Elliott, which voted to declare the skipped payment a credit event, is said to have bought swaps betting on a Caesars default, according to people with knowledge of the purchases, who asked not to be named because the trades are private.

Goldman’s positions in the debt or the CDS have not been reported. But that’s OK, because there is no conflict of interest provision in ISDA’s rules for members of the Determination Committee. Neither is there any requirement that they disclose what information they use in that decision, nor even any requirement that the information used is true. Completing the trifecta of non-disclosure, ISDA and its Determination Committee have no oversight from any regulator.

I grew up in the financial business hearing the phrase “gnomes of Zurich,” an imaginary secret group of financiers who controlled precious metals and currencies worldwide. While that may have been the feverish delusions of conspiracy theorists, you’ve got to admit that the Determination Committee is pretty close to a twenty-first century group of “gnomes.”

Before we name ISDA’s Determination Committees today’s gnomes by acclamation, we should consider some of the other candidates. For example, the Private Equity crew. The Caesar’s situation gives us a prime example of how this small group wields unusual power.

When two-thirds of the senior bond investors agreed to the plan filed in Chicago, the private equity shareholders seem to have gotten themselves far better treatment than their position in the “capital stack” of the company would normally get. The junior bondholders get almost nothing, while the equity guys get to keep control of the best assets and a huge chunk of equity in the post-bankruptcy company.

The Reuters article on the proposed bankruptcy deal described it like this:

“The agreement with first-lien noteholders follows months of talks and corporate reshuffling, and junior creditors who are owed more than $5 billion have sued. Those creditors allege that choice assets were put beyond their reach for the benefit of the parent company shareholders and the company’s private equity backers. “

The current situation came from the $29 billion private equity purchase (leveraged buyout) of Harrah’s Entertainment Corp. by TPG Capital and Apollo Global Management in 2008. As I see it, somehow TPG and Apollo actually left some of their own money (about $5 billion) at risk in the deal, though I haven’t seen any reports describing how much they’ve taken out in fees and management compensation in the years since the deal was completed.

By cutting a deal with the most senior bondholders, the private equity guys seem to be jumping right over the bondholders that have legal priority over them in a liquidation. Of course, with the CDS “side bet” again dwarfing the actual debt, another group of big money players have their game going on, too. Who knows? Maybe TPG and Apollo have $10 billion in CDS, so they’ll turn a nice profit on the default, and another nice profit on the REIT they plan to form with the successful casinos. Win-Win. Or maybe even Win-Win-Win.

Strangely, what isn’t being debated is the policy issues of tax treatment for LBO purchases and the destruction that tends to follow.

As my parable Death by Tax Cuts lays out, our tax code relatively punishes those who create wealth and rewards those who liquidate existing wealth, especially with the changes since 1981. Further, by personally rewarding the people who engineer these takeover deals with deferred taxation at vastly lowered rates even when they don’t risk their own capital, we seem to be committed to handing our domestic capital base to a handful of people who enjoy all the benefits of America while “holding” the wealth they liquidate in offshore tax havens.

Maybe the correct phrase should be “Gnomes of Greenwich” or “Hamptons Gnomes.” Or maybe they really are tiny gnomes, since the legal residences of most of these hedge funds and private equity outfits are cabinet drawers in the Caymans.

hh

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