Opinion

Felix Salmon

Are CDS holders dooming Gannett?

By Felix Salmon
June 23, 2009

Are you ready for 3,000 words on Gannett newspapers, credit default swaps, and the negative basis trade? In that case, Richard Morgan is your man. But boiled down to its essentials, Morgan is making a strong form of the same argument we’ve been hearing for a while — that when bondholders are fully (or more-than-fully) hedged in the CDS market, they can have an incentive to push a company into default.

In the case of Gannett, there are likely quite a lot of such bondholders, thanks to the negative basis trade: if traders buy Gannett debt, buy the same amount of default protection, and hold to maturity, then they’re pretty much guaranteed a substantial risk-free profit (putting to one side, for one minute, the question of counterparty risk).

Now the negative-basis trade is a dangerous thing, for people who mark to market: it can move against you drastically, and it was probably responsible for a very large chunk of Merrill Lynch’s devastating fourth-quarter losses. But large arbitrage opportunities are rare things, and it makes sense to assume that a lot of Gannett’s debt is held by arbitrageurs rather than anybody with a particular interest in Gannett’s long-term health.

That said, of course, for every buyer of Gannett default protection, there’s a seller. And if the people who bought Gannett CDS have an incentive to see the company default, then the people who sold Gannett CDS have an incentive to buy up the bonds (which are now very cheap) and help the company avoid default.

And for all the length of Morgan’s piece, he doesn’t seem to have talked first-hand to Gannet bondholders, or anybody on either side of the Gannett CDS trade. Which makes the whole thing weirdly speculative. I’m sure that the CDS situation is complicating Gannett’s liability management operationds. But I’m not convinced that it’s quite as harmful as Morgan makes out.

Comments
4 comments so far | RSS Comments RSS

“…the people who sold Gannett CDS have an incentive to buy up the bonds (which are now very cheap) and help the company avoid default.”

Assuming, that is, that the seller is not in a position similar to AIG. Then they just might say “Oops! Looks like we wrote some insurance we can’t cover. Sorry!” The CDS buyers would then be out of luck, unless the government stepped in again.

Posted by Ken | Report as abusive
 

Can you provide some additional detail/explanation of the negative basis trade or point me to some articles that explain its mechanics? Is the idea simply that that the amount you pay in premiums on the cds you buy is less than the interest payments you receive on holding the bond, and you are guaranteed to receive par at maturity? Does the relationship always run in this direction or is it sometimes reversed (i.e. are the cds premiums ever higher than the bond interest payments)? If the bond pays more in interest than the premium payments on the cds, is it merely a function of counterparty risk? What would be the explanation for the bonds paying less than the cds premiums? Anything you could point me to would be much appreciated. Thanks.

Posted by robby | Report as abusive
 
 

Who is writing these CDS’s on Gannett? Is it more CDS junk left over from AIG?

In that case, the government would be actually helping to pay for companies to be destroyed. Beautiful. That needs to stop. If the government is paying on CDSs through AIG, it should at least do so at a level far lower (say 50 cents on the dollar, purely to help resist deflation) that pushes creditors to the table.

It should be that creditors and business managers struggle hard together to find value and savings.

Felix, you are a good man for bringing this to the attention of so many.

Pray tell, who is the ultimate payer on most of these Gannett CDS contracts?

Posted by Dan Hess | Report as abusive
 

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