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A bondholder finds a sneaky way to trigger insurance against default

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IN 2013 Codere, a Spanish gaming firm, owed money it could not repay. Its bonds were trading at just over half face value. Blackstone, a private-equity firm, offered it a cheap $100m loan. But there was a catch. Blackstone had bought credit derivatives on Codere’s debt that would pay out about €14m ($19m) if Codere missed a bond payment. So Codere delayed a payment by a couple of days to prompt a “technical default”. Blackstone got its payout; Codere got its loan and stayed afloat.

On the satirical “Daily Show”, Jon Stewart, the then host, likened the scheme to the insurance fraud in “Goodfellas”, in which mobsters insure a restaurant before blowing it up. But that missed an important point. Blackstone did not blow Codere up—quite the opposite. As it said at the time, it “provided capital when no one else would, which allowed the company to live and fight another day”. The investors who sold Blackstone credit-derivative contracts had in effect bet that Codere would not go bankrupt. Without the loan, it probably would have. Those investors would still have paid for their error.

Those machinations pale in comparison with Blackstone’s latest financial wizardry. In 2017 Blackstone bought $333m-worth of credit derivatives on Hovnanian, an American construction firm. It offered Hovnanian cheap financing on condition that it trigger those derivatives to pay out. But Hovnanian is in better shape than Codere. Though its bonds are junk-rated, it is hardly flirting with bankruptcy.

That posed two problems. The first is that missing a payment would harm Hovnanian’s image. But Blackstone found an ingenious workaround. A condition of the financing was that a subsidiary of Hovnanian bought $26m of its bonds. On May 1st Hovnanian paid other bondholders but defaulted on those held by the subsidiary.

The second problem is trickier. The derivatives, called credit-default swaps (CDSs), pay the difference between the notional value of a bond and the lowest price at which any of the company’s bonds is trading when the CDS is triggered. This is usually a good proxy for the haircut investors would have to take after a firm’s bankruptcy. If it can pay back only half its debt, its bonds should be trading at around half face value, and the CDS will cover the rest. That makes sense when a company actually defaults, and all bond claims fall due.

Hovnanian required a different approach. Bonds are usually issued “at par”, meaning investors get back the face value at the end of the term. In the meantime, they receive interest (the coupon). The coupon depends partly on how confident investors are that the loan will eventually be repaid in full.

If all Hovnanian’s bonds had been trading close to par, then a technical default would have resulted in a tiny payout. And indeed, most were. But Blackstone’s cheap financing took the form of buying a 22-year bond Hovnanian had recently issued with a 5% coupon—a combination of interest and term that even the bluest of blue-chips could not issue at par. Trading at less than half face value, it is the reference against which Blackstone’s CDS will be valued.

Those who must pay out are, unsurprisingly, irked. One regulator thinks they have a point. America’s Commodity Futures Trading Commission suggests technical default may count as market manipulation. But company CDSs fall under the Securities and Exchange Commission, which has said nothing. Courts, so far, have upheld the actions of Hovnanian and Blackstone. One of the CDS sellers, Solus Asset Management, a hedge fund, was denied an injunction to stop the technical default. Blackstone says it remains “highly confident” that its arrangement with Hovnanian is “fully compliant with the long-standing rules of this market”.

CDSs were intended as a hedge against losses from defaults, not a bet on a firm deciding to trigger them. But Blackstone’s machinations seem to have broken the spirit, rather than the letter, of the rules. Even Bennett Goodman, the boss of its credit-investment arm, has expressed his support for a rewrite. “If people want to change the rules…because they think it makes for a more effective market structure, we are all for it,” he said in March. That would indeed be good, fellas.

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Japan still has great influence on global financial markets

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IT IS the summer of 1979 and Harry “Rabbit” Angstrom, the everyman-hero of John Updike’s series of novels, is running a car showroom in Brewer, Pennsylvania. There is a pervasive mood of decline. Local textile mills have closed. Gas prices are soaring. No one wants the traded-in, Detroit-made cars clogging the lot. Yet Rabbit is serene. His is a Toyota franchise. So his cars have the best mileage and lowest servicing costs. When you buy one, he tells his customers, you are turning your dollars into yen.

“Rabbit is Rich” evokes the time when America was first unnerved by the rise of a rival economic power. Japan had taken leadership from America in a succession of industries, including textiles, consumer electronics and steel. It was threatening to topple the car industry, too. Today Japan’s economic position is much reduced. It has lost its place as the world’s second-largest economy (and primary target of American trade hawks) to China. Yet in one regard, its sway still holds.

This week the board of the Bank of Japan (BoJ) voted to leave its monetary policy broadly unchanged. But leading up to its policy meeting, rumours that it might make a substantial change caused a few jitters in global bond markets. The anxiety was justified. A sudden change of tack by the BoJ would be felt far beyond Japan’s shores.

One reason is that Japan’s influence on global asset markets has kept growing as decades of the country’s surplus savings have piled up. Japan’s net foreign assets—what its residents own abroad minus what they owe to foreigners—have risen to around $3trn, or 60% of the country’s annual GDP (see top chart).

But it is also a consequence of very loose monetary policy. The BoJ has deployed an arsenal of special measures to battle Japan’s persistently low inflation. Its benchmark interest rate is negative (-0.1%). It is committed to purchasing ¥80trn ($715bn) of government bonds each year with the aim of keeping Japan’s ten-year bond yield around zero. And it is buying baskets of Japan’s leading stocks to the tune of ¥6trn a year.

Tokyo storm warning

These measures, once unorthodox but now familiar, have pushed Japan’s banks, insurance firms and ordinary savers into buying foreign stocks and bonds that offer better returns than they can get at home. Indeed, Japanese investors have loaded up on short-term foreign debt to enable them to buy even more. Holdings of foreign assets in Japan rose from 111% of GDP in 2010 to 185% in 2017 (see bottom chart). The impact of capital outflows is evident in currency markets. The yen is cheap. On The Economist’s Big Mac index, a gauge based on burger prices, it is the most undervalued of any major currency.

Investors from Japan have also kept a lid on bond yields in the rich world. They own almost a tenth of the sovereign bonds issued by France, for instance, and more than 15% of those issued by Australia and Sweden, according to analysts at J.P. Morgan. Japanese insurance companies own lots of corporate bonds in America, although this year the rising cost of hedging dollars has caused a switch into European corporate bonds. The value of Japan’s holdings of foreign equities has tripled since 2012. They now make up almost a fifth of its overseas assets.

What happens in Japan thus matters a great deal to an array of global asset prices. A meaningful shift in monetary policy would probably have a dramatic effect. It is not natural for Japan to be the cheapest place to buy a Big Mac, a latté or an iPad, says Kit Juckes of Société Générale. The yen would surge. A retreat from special measures by the BoJ would be a signal that the era of quantitative easing was truly ending. Broader market turbulence would be likely. Yet a corollary is that as long as the BoJ maintains its current policies—and it seems minded to do so for a while—it will continue to be a prop to global asset prices.

Rabbit’s sales patter seemed to have a similar foundation. Anyone sceptical of his mileage figures would be referred to the April issue of Consumer Reports. Yet one part of his spiel proved suspect. The dollar, which he thought was decaying in 1979, was actually about to revive. This recovery owed a lot to a big increase in interest rates by the Federal Reserve. It was also, in part, made in Japan. In 1980 Japan liberalised its capital account. Its investors began selling yen to buy dollars. The shopping spree for foreign assets that started then has yet to cease.

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