Hedge Fund Gambit Stirs Fresh Controversy in Besieged CDS Market

(Bloomberg) -- It seemed like a sure-fire bet: short the debt of a highly leveraged newspaper company that's losing money. And for a while, it worked as investors piled up almost $500 million of wagers by buying credit-default swaps on the publisher, McClatchy Co.

That is until hedge fund Chatham Asset Management stacked the deck with a deal that's threatening to make those swaps all but worthless.

The McClatchy situation is the latest trade that's drawing jeers from critics who say the $11 trillion CDS market has devolved into a haven for manipulation. One regulator has already warned it's looking at practices in the market after another trade by Blackstone Group LP's credit arm that would engineer a default by a homebuilder and allow it to collect on $333 million of CDS.

“CDS is being manipulated to the point that it potentially invalidates the product,” says Mike Terwilliger, a money manager at Resource America Inc. “Fundamentally, markets rely upon valid prices. How can I use a product if I need to worry that counterparties are trying to vandalize capital structures to contort CDS contracts?”

Gold Rush

In the McClatchy trade, New Jersey-based Chatham struck a deal with the newspaper publisher -- founded in California on the heels of the Gold Rush -- to refinance most of its $710 million of debt with two new loans. The loans will allow the company to trim about $50 million off its most expensive bond and give it a few more years to repay the bulk of its debt. The news did little to boost McClatchy's $72 million market cap. But because of a condition in the deal with Chatham that would move McClatchy's borrowings into a new wholly owned subsidiary, the impact was seismic for holders of the derivatives.

In a matter of hours, the refinancing wiped out 70 percent of the market value of a five-year CDS on McClatchy, data compiled by Bloomberg and price provider CMA show.

That was bad news for the hedge funds, banks and other investors that had bought insurance against a McClatchy default. Because the new debt would be shifted away from the parent and into the new unit, it's fueling speculation that the Chatham deal will create what's commonly known in the CDS world as an orphaned contract. In other words, anyone who bought insurance on a McClatchy default would effectively be paying insurance on an entity with no significant debt.

But for Chatham, the deal could bring a potential windfall. Leading up to the deal, Chatham had been selling swaps insuring against a default by McClatchy. So if the transaction were to be completed, it would be getting paid CDS premiums to guarantee against a default that could never technically happen.

A spokesman for Chatham declined to comment. A representative for McClatchy, which owns newspapers including the Miami Herald and Sacramento Bee, didn't respond to requests for comment.

“It's 100 percent fair to take the opposite side of a trade,” said Jochen Felsenheimer, the Munich-based managing director at XAIA Investment GmbH. "But if then you do something bilaterally with the company, that isn't a fair trade.”

In addition to the CDS trades, Chatham had been snapping up McClatchy bonds for months, collecting $356 million of its $365 million of debentures. The buying drove the price of one of those bonds -- those maturing in 2029 -- to 125 cents on the dollar, making it the best performer in a Bloomberg Barclays junk-bond index this year. McClatchy has said the loans will be priced relative to the fair trading value of the bonds, which means Chatham may be issued the loans at a premium to par, the publisher's executives said on an earnings call last week.

The deal is still contingent on McClatchy's ability to refinance almost 300 million of first-lien bonds due in 2022 that Chatham doesn't own.

Reverse of Hovnanian

In many ways, the McClatchy deal could shape up to be the opposite of the Hovnanian Enterprises Inc. trade orchestrated by Blackstone's GSO, which has gripped the derivatives market for months.

GSO has been embroiled in a lawsuit over its maneuver with the New Jersey-based homebuilder over the trade. The Commodity Futures Trading Commission last week sent a warning to market participants that it may act to prevent manipulation “to help ensure market integrity.”

“The whole market is losing credibility when you have events like this where you try to trigger the CDS or create orphaning situations,” XAIA's Felsenheimer said.

To contact the reporter on this story: Sridhar Natarajan in New York at snatarajan15@bloomberg.net.

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Shannon D. Harrington, Dan Wilchins

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