We have talked a few times recently about Hovnanian Enterprises Inc., which got favorable financing from Blackstone Group's GSO Capital Partners through some credit-default-swap market machinations. GSO had bought CDS protection that would pay off if Hovnanian defaulted. Hovnanian will refinance its debt with a series of new instruments, including a favorable new term loan from GSO but also some new 22-year bonds with a comically below-market interest rate of 5 percent, which should trade at something like 50 cents on the dollar. Those bonds -- along with more valuable bonds, adding up to an attractive total package -- will be issued in exchange for some of its old bonds, pushing out its debt maturities and relieving some of its financial pressure.
But it also plans to buy (through an affiliate) $26 million worth of the old bonds, keep them outstanding, and default on an interest payment just to those bonds. Hovnanian will default on a payment it owes to itself, but keep paying off all of its external bondholders. This shouldn't bother the bondholders, but it should trigger the credit-default swaps. And because some of the new bonds will be worth something like 50 cents on the dollar, those credit-default swaps (which pay out more the less Hovnanian's bonds are worth) should be worth a lot. GSO will make a nice profit on its CDS, and will use some of that profit to subsidize some cheap financing for Hovnanian.
I once wrote about it:
It's quite a trade! One thing that is elegant about it is that it doesn't require Hovnanian to "really" default: It has to miss an interest payment, but only an interest payment due to its own affiliate. (Outsiders who keep the 8 percent bonds after the exchange offer will still get paid.) No third-party creditor will be harmed by the default, so no bond or loan investor will have any cause to complain, or to refuse to finance Hovnanian in the future, or to sue Hovnanian's directors for defaulting in bad faith. The only people harmed by these machinations will be the people who wrote credit-default swaps -- and I suppose it is reasonable for Hovnanian not to care too much about what they think.
That was a bit hasty: You can get sued for anything. And so last week Solus Alternative Asset Management LP, a hedge fund that wrote credit-default swaps on Hovnanian, sued the company, its chief executive officer and chief financial officer, and GSO, for ... something? The problem is that Hovnanian really isn't doing anything to Solus. Solus wrote some CDS on Hovnanian, but Hovnanian wasn't a party to that CDS and has no obligations to Solus under it. So the lawsuit consists of a lot of hand-waving and shouting about fraud. "The Defendants, directly and indirectly, by the use, means, or instrumentalities of interstate commerce and/or of the mails, engaged in deceptive or manipulative acts to engineer a fraudulent, sham payment default by Hovnanian and the issuance of a Rigged Bond whose off-market terms will drive its price well below par and result in an inflated recovery on Hovnanian CDS contracts," says the complaint, to which Hovnanian might reasonably respond "yeah what of it?" Hovnanian isn't defaulting, fraudulently or otherwise, on a payment owed to Solus; it's not forcing Solus to buy any bonds, rigged or otherwise. Solus's objection is strangely aesthetic: Hovnanian's new bonds are so ridiculous that they just shouldn't be allowed to exist.
To put the absurdity of the Rigged Bond into perspective, there is not a single high-yield issuer rated by Moody’s or S&P with Hovnanian’s credit rating (or worse) that has outstanding unsecured debt maturing more than 10 years in the future, let alone the 22-year maturity proposed for the Rigged Bond. Any arms-length investor willing to lend money to a company for that extended length of time typically demands a higher interest rate to compensate them for committing capital for that long; yet, the annual interest rate on the Rigged Bond is half of the 10% interest rate on Hovnanian’s own secured bonds that would mature eighteen years before the Rigged Bond. Indeed, given these wildly off-market terms, credit analysts at global investment banks have speculated that the Rigged Bond will trade at no more than 50 cents on the dollar while the company’s legitimate unsecured bonds are currently trading around par.
Perhaps more seriously, there is a claim that Hovnanian's exchange offer documents are misleading, "disclosing obliquely that its agreement to default on interest owed on its notes 'may' trigger a credit event when, in fact, the true but concealed nature and purpose of the transaction is a commercial bribe intended to trigger a CDS credit event for the sole purpose of enriching GSO in exchange for the provision of below-market financing."
"The intended effect of Hovnanian’s complicity in GSO’s scheme," says Solus, "is to deliver hundreds of millions of dollars of illicit CDS payouts to GSO and other CDS protection buyers at the direct expense of innocent CDS protection sellers, like Solus." There is a lot of that sort of emotional appeal: Think of the poor innocent CDS protection sellers! "In selling CDS protection on Hovnanian debt," the complaint says, "Solus relied upon a normally functioning market in which payment defaults occur as a result of actual financial distress, and borrowers endeavor to abide by their contractual obligations." But again that is no concern of Hovnanian's. Hovnanian didn't invent the CDS market, or buy or sell any CDS itself. Hovnanian never asked Solus or anyone else to sell CDS on itself; Hovnanian would have been perfectly happy if anyone who had wanted to invest in its credit had just bought its bonds rather than entering into zero-sum third-party derivative side bets. But they entered into the side bets, and GSO found a way to turn those bets into money for Hovnanian (and GSO), and Hovnanian took it. It's hard to see why it wouldn't.
AI
