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.


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