Wall Street looks for fix to shady credit default swap market amid Windstream bankruptcy

In the wake of the recent Windstream bankruptcy filing, top Wall Street banks, financiers and hedge funds are moving forward with a possible fix to “clean up an $8 trillion portion of the derivatives market that’s gained a reputation for being one of the shadiest corners in finance,” according to a Bloomberg article published last week.

The article notes that in recent years there have been several major deals 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, known as credit default swaps, has eroded market confidence, triggered legal fights and led to scrutiny from regulators, it said.

The industry-led reforms come at a time when Windstream and other distressed publicly traded companies have raised concerns of the gaming of CDS’s during and following the Great Recession. In a recent interview with Talk Business & Politics, University of Texas law professor Henry Hu said the valuable financial innovation that Windstream used to close the Uniti deal “is susceptible to opaque gaming and counterintuitive incentives.”

The Windstream bankruptcy directly resulted from a ruling by U.S. District Judge Jesse Furman for the Southern District of New York on Feb. 15 that Windstream violated bond agreements after it had successfully completed a tranche of debt swap offerings and consent solicitations first announced in October 2017.

Furman’s decisive ruling arose from challenges by Aurelius and U.S. Bank National Association that the 2015 deal was invalid under the terms of a debt exchange offer and consent solicitations in respect to senior notes issued by its Windstream Services LLC to finance the spinoff of Arkansas’ first publicly traded real estate investment trust (REIT), now known as Uniti Corp. The court further ruled that Aurelius was entitled to a $310.5 million judgment, plus interest from and after July 23, 2018.

“Certain changes in the CDS market could be helpful to companies, traditional creditors, investors, CDS sellers, and overall market efficiency. For instance, greater disclosure of CDS positions can make sense,” Hu said in an interview with Talk Business & Politics. “But even leaving aside regulatory or industry-wide changes, individual companies, creditors, and investors can try addressing a number of the issues that appear to be at play in the Aurelius/Windstream matter.”

A ‘PLAYGROUND’ FOR CREATIVE TRADERS, LAWYERS
According to Bloomberg, the International Swaps and Derivatives Association (ISDA) 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 Wall Street trade group, which represents financial banking and investment giants such Goldman Sachs Group Inc., JPMorgan Chase & Co., Apollo Global Management and Ares Management Corp., proposes to re-define “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,” the Bloomberg article states.

The ISDA 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, Bloomberg states.

“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 a document sent to its members on Wednesday.

Like views expressed by Hu in a Feb. 24 column for the influential London-based Financial Times broadsheet, the Bloomberg article stated that the “tipping point” for the credit swap crisis 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.

Other investment firms that were at risk of losing money protested because they had sold CDS’s insuring against a missed payment. One hedge fund, Solus Alternative Asset Management, even sued GSO, which ultimately agreed to unwind its trade, the article noted.

Hu compared the Windstream bankruptcy with what he called a “manufactured default” “involving New Jersey-based Hovnanian, which has put a reverse stock split proposal before shareholders at the homebuilder’s March 19 annual meeting to address a delisting notice from the New York Stock Exchange after the company’s stock price fell below $1 per share for 30 straight days.

Hovnanian, which closed at 60 cents per share on Wednesday, was given six months following the NYSE notice on Jan. 9 to regain compliance. Unlike the East Coast homebuilder, Windstream decided last week to be delisted from the Nasdaq stock exchange instead of complying with its 30-day trading requirement to keep its common stock above $1.

According to Windstream’s balance sheet, the rural broadband carrier currently has total debt outstanding of $5.84 billion, $4.7 billion of which is senior unsecured notes due between 2020 and 2023. In conjunction with Chapter 11 filing, Windstream received a commitment from Citigroup Global Markets, which was the lead backer in an earlier Windstream debt-for-equity swap in July 2016, for $1 billion in financing.

Following approval by the federal court, $400 million of that financing, combined with access to the cash generated by ongoing operations, will be available to meet Windstream’s operational needs and continue operating its business as usual, company officials said.

AURELIUS BET
In regards to the Aurelius matter, Windstream has indicated that it plans to appeal the Manhattan court’s $310 million decision, accusing the New York-based hedge fund that also played a significant role in the $70 billion default of Puerto Rico’s debt loan of engaging in “predatory market manipulation to advance its own financial position through credit-default swaps at the expense of many thousands of shareholders, lenders, employees, customers, vendors, and business partners.”

And although Aurelius has not yet confirmed its position in Windstream, the Street’s widely-held belief is the New York hedge fund also has a far larger investment in the Arkansas company’s credit default swaps. In September 2017, the hedge fund first sent a notice to Windstream alleging that the Arkansas telecom had breached a provision of a debt contract in its 2015 spinoff of Uniti Corp. into Arkansas first publicly held REIT, setting a chain of events that Windstream officials say pushed the Arkansas company into bankruptcy.

“Windstream stands by its decision to defend itself and try to block Aurelius’ tactics in court. The time is well-past for regulators to carefully examine the ramifications of an unregulated credit default swap marketplace,” Windstream President and CEO Tony Thomas stated after the company’s Chapter 11 bankruptcy filing.

“Windstream did not arrive in Chapter 11 due to operational failures and currently does not anticipate the need to restructure material operations,” said Thomas, disagreeing with Furman’s ruling. “While it is unfortunate that Aurelius engaged in these tactics to advance its returns at the expense of Windstream, we look forward to working through the financial restructuring process to secure a sustainable capital structure so we can maintain our strong operational performance and continue serving our customers for many years to come.”

Hu said if it turns out that Aurelius has a position in Windstream as an “extreme empty creditor,” then the Wall Street hedge fund run by former New York bankruptcy attorney Mark Brodsky had an incentive to push the Arkansas telecom into default.

“Extreme empty creditors often have incentives to nudge borrowers into bankruptcy. On bankruptcy, the payoff on their CDS’s would exceed the losses on what they’ve lent,” said Hu. “If Aurelius turns out to be an extreme empty creditor, this Aurelius/Windstream situation is the significant example of the counterintuitive incentives of such creditors that I’ve long been concerned about.”

Windstream officials would not comment on the current efforts by Goldman Sachs, JPMorgan and other top Wall Street banks and investment firms to regulate the CDS market. The Arkansas-based rural broadband carrier also did not offer any details on its timetable to file its reorganization plan with the federal bankruptcy court in Manhattan.