Wall Street banks and hedge funds are closing in on a fix that they hope will clean up an $8 trillion portion of the derivatives market that’s gained a reputation for being one of the shadiest corners in finance.
At issue are a number of transactions in recent years in which powerful investment firms have been accused of earning big money from swaps trades by enticing companies to miss bond payments they could otherwise make. The practice has eroded market confidence, triggered legal fights and led to scrutiny from regulators.
The industry’s main trade group on Wednesday proposed re-defining “failure to pay” events that trigger payouts. The plan aims to ensure that such defaults are tied to legitimate financial stress, rather than traders’ derivatives bets. The changes, if completed, would be among the biggest to hit credit default derivatives in years and could help beat back a perception that the market has become a playground for creative traders and lawyers.
Specifically, International Swaps and Derivatives Association is proposing that failing to make a bond payment wouldn’t trigger a CDS payout if the reason for default wasn’t tied to some kind of financial stress. The plan earned initial backing from titans including Goldman Sachs Group Inc., JPMorgan Chase & Co., Apollo Global Management and Ares Management Corp.
“There must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity,” ISDA said in its document.
The revamp would affect credit-default swaps, instruments that contributed to the 2008 financial crisis that insure against a bond issuer’s bankruptcy or failure to pay. But the fix is limited to one type of deal, so-called manufactured defaults.
A trade that was widely seen as a tipping point occurred last year when Blackstone Group LP’s GSO Capital Partners encouraged homebuilder Hovnanian Enterprises Inc. to skip an interest payment in return for a sweetheart loan. Firms that were at risk of losing money protested because they had sold CDS insuring against a missed payment. One hedge fund, Solus Alternative Asset Management, even sued GSO, which ultimately agreed to unwind its trade.
“People had become gun-shy about using the CDS product to invest in and manage credit risk,” said John Williams, a law partner at Milbank who represents buyside firms active in the CDS market including Apollo and Ares. “This is a very serious effort to make the rules fair.”
In the wake of the Hovnanian controversy, Bennett Goodman, one of the founders of GSO, said that Blackstone would back revamping the standards that govern CDS trades. Blackstone wasn’t formally part of the group that reached the preliminary agreement, according to a person familiar with the matter, but there is no indication it will oppose the plan.
Representatives for Blackstone, JPMorgan, Goldman Sachs, Apollo and Ares didn’t respond to requests for comment on the proposal.