Once upon a time in America, when banks or investors lent money to a company they expected to receive years of agreed-upon interest payments plus the return of the money borrowed. If the business did well, the lenders were paid back on time and made money. So they wanted the company to succeed.
Not any more.
Instead, the misuse of financial instruments is creating perverse incentives, rewarding crafty creditors for forcing companies into bankruptcy. Thanks to a lack of rules requiring creditors to be transparent, companies, their employees and their investors may have no way of knowing a creditor's real intentions until it's too late.
The main culprit is a form of financial insurance called credit-default swaps and the hedge fund wiseguys who wield them like cudgels. Credit-default swaps, you may remember from the 2008 financial crisis, allow creditors to insure themselves against the risk that the borrower responsible for debt they own might go into default. Buying insurance means that in case of default they can still get paid back 100 cents on the dollar.
All that's needed to buy this--as with any insurance--is to find a company willing to sell it to you, whether it's an actual insurance company or another financial entity, and then to pay the annual premium. The cost of the insurance premium fluctuates depending on the perceived risk of the debt being insured.
For example, when General Electric announced in February that it would pay down some of its $107 billion in debt, the price of insurance on a $10 million chunk of G.E. debt fell to around $92,000 a year. Back in November, when the risk of a G.E. default seemed higher, the annual cost was $280,000.
What hedge funds have been doing is buying the debt of troubled companies at a discount, for pennies on the dollar, from creditors who are eager to unload it, and then purchasing insurance on the full value of the debt. If the company later defaults on the debt, that clever strategy can pay off big time.
So instead of trying to find ways to keep a company out of bankruptcy--say, by restructuring repayments or lowering the interest rate owed or adjusting other terms of a loan covenant to avoid default--hedge fund managers have been pushing the companies that owe them money into bankruptcy. The hedge funds figure they can make more money from the insurance payoff than they can from getting their principal repaid.
While that tactic may be perfectly legal and highly rewarding for the hedge fund, it's a disaster for everyone else: the company and its employees suddenly faced with bankruptcy, other creditors who haven't insured their risk and, of course, the insurers who have to make good on the defaulted debt.
That's basically what happened in February to Arkansas-based rural Internet and telecommunications company Windstream. One of its creditors, a hedge fund called Aurelius Capital Management, went to court and successfully argued that Windstream was in technical default when it spun off one part of its business. None of the other creditors objected, but the judge sided with Aurelius, and the $310 million of Windstream's debt that Aurelius owned was immediately due and payable. Windstream could not make the payment, so it filed for bankruptcy, and its stock price fell by two-thirds.
It turned out that Aurelius had also bought credit-default swaps on its Windstream debt that were worth a huge amount--as much as 10 times the debt it owned, Windstream believes--giving the hedge fund a significant incentive to force the company into bankruptcy in order to collect the insurance money. Windstream discovered Aurelius' purchase of the credit-default swaps only after the fact.
Regulators apparently stood by and did nothing. There is no limit on the dollar amount of credit-default swaps that can be bought. That allows a hedge fund with a clear interest in a default to bet as much money as it wants on that outcome. It sets an awful precedent if a creditor can benefit more from a company's bankruptcy than from its solvency.
Windstream's chief executive Tony Thomas is still reeling from the experience. "You can no longer assume the people investing in your debt instruments are going to be aligned to your interests," he told me.
Aurelius, founded by former bankruptcy attorney Mark Brodsky, declined to comment.
Within weeks of his Windstream windfall, Mr. Brodsky was at it again. Aurelius is also a creditor of Neiman Marcus, the struggling luxury retailer. Neiman has been trying to restructure more than $5 billion of debt, and to do so it agreed in March, as part of a comprehensive restructuring, to allow Aurelius and other creditors to buy credit-default swaps on its Neiman debt.
Another Neiman Marcus creditor, Daniel Kamensky at Marble Ridge Capital, called what Aurelius extracted out of Neiman Marcus "a spectacular 'Devil's Bargain.'"
What can be done about these perverse incentives?
• The Securities and Exchange Commission should immediately require greater disclosure of credit-default swap positions held by creditors. It's the only way for a company, its investors and its employees to have a transparent understanding of a creditor's motivations.
• Once those positions are disclosed, the SEC should help companies protect themselves from hostile creditors. The agency could, for example, allow companies to revise the terms of their bond agreements so that creditors with credit-default swaps don't have the same voting rights as creditors who want a company to succeed.
• The definition of "failure to pay" and other conditions that might set off a default could be revised to make it harder for a hedge fund to push a company into technical default. Judges can play an important role by taking the creditors' motivations into account as more of these cases inevitably wind up in the courts.
Even though the economy continues to hum, the risk to over-leveraged companies from creditors like Aurelius is growing. The amount of corporate debt outstanding since the 2008 financial crisis has exploded to around $9 trillion, from $5.5 trillion a decade ago. That's a lot of debt, great chunks of which could default.
The Latin root of the word "credit" translates as "to believe," as in to believe your money will be paid back. A failure to protect America's credit markets undermines the trust that is at the heart of the entire financial system.
"When that trust falls away," Tony Thomas at Windstream told me, "every time you're sitting across the table from an investor it runs through my mind: Are you working in our interests, or are you trying to screw me?"
William D. Cohan, a special correspondent for Vanity Fair, is a former investment banker and the author of four books about Wall Street.
Editorial on 05/26/2019