Monday, October 5, 2009

Goldman purchase puts CDS in focus

Posted in the Financial Times by Henny Sender:

The relationship between Goldman Sachs and ailing commercial lender CIT provides further evidence that the credit default swap market can put a company in jeopardy.

Credit default swaps have become an increasingly contentious issue in debt restructurings such as the one that CIT is now trying to complete. Many creditors who hold such insurance make more if a company files for Chapter 11 bankruptcy protection than they make on their debt if the company succeeds in restructuring its debt outside of bankruptcy.

In the case of CIT, market players have bought more insurance than the company’s $30bn in debt. Those holders include Goldman, who purchased such a credit protection to hedge against a June 2008 rescue financing of up to $3bn to CIT, Goldman said. Goldman also held other CIT debt, although the company declined to comment on these other exposures.

Goldman carefully structured the rescue financing so that it was heavily collateralised. But as markets plunged, concerned about the value of that collateral, Goldman bought credit default swaps to hedge its exposure. However Goldman declined to comment on the amount.

Goldman purchased the credit default swaps to “prudently manage the risk associated with the CIT financing,” it said, adding that the swaps “are not a directional ‘bet’ on CIT”.

However, today markets have stabilised and Goldman is over-collateralised on rescue financing. And thanks to the position in credit default swaps, Goldman will actually profit in the event CIT files for Chapter 11 bankruptcy protection in what one regulator describes as a “double bonanza”.

People familiar with the matter say Goldman has no desire to see its client file for Chapter 11. It is in fact trying to renegotiate the rescue financing.

But regardless of Goldman’s intention, it would profit handsomely if CIT were to file for bankruptcy protection. Before the company could even arrange the so-called debtor in possession financing to survive in bankruptcy, it would have to pay Goldman $1bn – as part of a make whole agreement – while Goldman’s valuable credit insurance would pay off at once.

To many analysts, the fact that such insurance can mean that a group of holders have an incentive to see a company file for Chapter 11 is perverse. The matter is delicate – it is always difficult to draw a distinction between hedging and speculating. What begins as hedging may end up being the opposite – the outcome market players are hedging against becomes the preferred outcome.

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