Author Topic: SHLD - Sears  (Read 2586229 times)

Hielko

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Re: SHLD - Sears
« Reply #9240 on: Today at 02:42:37 AM »
I think the author of the article doesn't understand how it works, or I'm totally wrong... because I think it's exactly the other way around, the CDS protection buyers can deliver bonds to the auction, doesn't make sense for the CDS protection seller. Here is how I think it works:

Normally CDS are bought as a hedge:

1. How much a CDS pays is determined based on the price of some bonds that are sold in an auction.
2. If you own the CDS and the bonds you sell your bonds in the auction, and the CDS will payout the difference. No matter how the bonds are priced in the auction, you get your money back.

Now, you only bought the CDS:

1. How much you get for your CDS is totally dependent on the auction. But if people for some reason are willing to pay par for the bonds, you will not get anything for your CDS.
2. And if someone has sold a lot of CDS - more than the notional of the outstanding bonds - he of course could "simply" buy all the bonds in the auction at par, and he doesn't have to pay a cent to people who bought the CDS.

Then he or she ends up up overpaying for some bonds, but that could make sense. Let's say the bonds are worthless. If you would have sold $1 billion in CDS you could lose that full $1 billion. But if there are only $200 million of bonds outstanding ,you could buy the $200 million in bonds. Lose $200 million on that because they are worthless, but then because they would be priced at par in the auction you wouldn't have to pay out a single cent to the CDS buyers.


Cigarbutt

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Re: SHLD - Sears
« Reply #9241 on: Today at 05:19:45 AM »
The problem happens during the auction process that is triggered by default. The auction is a two-stage process where market orders are solicited and where dealers put a floor and a cap in order to determine the recovery value of the bonds and calculate the amount of cash (cash settlement) that occurs between the CDS seller and the CDS buyer. Then bonds that entered the auction (volume may be small relative to total outstanding) are then matched between seller and buyer and are labeled as "physical delivery".

Fine in theory and usually works fine but "inefficiency" issues can occur with price discovery if the total volume of CDS is much larger than the underlying bond market of the entity and if some market "participants" have unusually large CDS positions where there may be incentives to influence the auction and price discovery process.

It has happened and, presumably, will happen again, perhaps big time.
There is a relevant thread on this topic with specific examples: "High yield debt and CDS market - Wild West".
The thread was more about how to engineer a default and benefit from it but the auction aspect is discussed.
Wonder how this applies to Sears.
https://www.kramerlevin.com/en/perspectives-search/opportunistic-cds-strategies-available-to-cds-protection-sellers-part-ii-mcclatchy-and-sears.html

aws

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Re: SHLD - Sears
« Reply #9242 on: Today at 08:52:42 AM »
That makes a lot more sense, but also reinforces why I keep a wide berth from the bond market as I have absolutely no idea about the games the big fish can play.  So then people buying now at possibly inflated prices might be naked CDS holders afraid they will get gamed and receive nothing, and they want to lock in a bond they can deliver at auction?  Hard to feel too sorry for the CDS holders though if they bought protection without holding the underlying bonds in the first place.

Cigarbutt

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Re: SHLD - Sears
« Reply #9243 on: Today at 09:50:26 AM »
Also remember that the CDS trigger is only a one-time event and should not change your longer term outlook on the outcome of the bonds.

FWIW, I think that the biggest risk for distortion is not from the CDS buyer without the underlying but from the CDS seller when the CDS market is larger than the underlying because net CDS sellers, by bidding above the fair value and eventually realizing a loss from buying the underlying bonds, can achieve a reduction in the net payoff to the existing CDS buyers, potentially resulting in an overall net gain versus not distorting the market. It looks like the distortion could be particularly significant if the auction is relatively illiquid. So, contrary to what Mr. Buffett is trying to achieve with his buyback activity, the market distorters aim to really move the market with the minimal amount of capital possible. Didn't Mr. Munger say something about the power of incentives?

It seems that the incentive issue used to be a larger problem when the payout of the CDS contract required physical delivery of the underlying bond (think Delphi in 2005, when the CDS market was much larger than the bonds) but with the Big Bang Protocol (these guys know how to name things), things have improved but the quest for efficiency has not been solved.

From the moral standpoint, it's not OK to create these situations but perhaps helpful to know about them. Isn't value investing about the discovery of mispricings?