Saturday, April 4, 2009

Moody's To Arbitrate When A Default Is Not A Default, Hedge Funds To Suffer

A little noticed document Moody's released on March 24 entitled "Moody's Approach to Evaluating Distressed Exchanges", could mean accelerated defaults for troubled companies pursuing debt buybacks in the open market, and the end of this practice, as companies will have no idea if Moody's will decide they merit the unenviable designation of "Limited Default."

Previously, a company pursuing "coercive" distressed tenders and exchange offers would immediately get a phone call from Moody's notifying it it had committed default under its debt. In the March 24's piece, Moody's had this to say on the topic:

In recent months, issuers have increasingly been proposing debt exchanges and tender offers at discounts to par. In many instances, these proposed exchanges reflect an opportunistic motivation as financially healthy issuers see a chance to reduce debt levels at attractive valuations. In other cases, however, the proposals are being made by financially distressed issuers and the effect of the exchange is to allow the issuer to ultimately avoid a default event, whether it is a bankruptcy filing or a missed payment on principal or interest.

Exchanges made by distressed issuers at discounts to par which have the effect of allowing the issuer to avoid a bankruptcy filing or a payment default (i.e., "distressed exchanges") are considered default events under Moody’s definition of default. However, since whether an issuer would have defaulted absent an exchange is unobservable, the determination of whether an exchange constitutes a default event is inherently a judgment call. As such, it is important for market participants to understand the criteria Moody’s considers in evaluating whether a particular exchange offer constitutes an event of default.
The critical take home message here is the subjective determination that Moody's and Moody's alone will make whether or not a company is to be branded a Defaulter or not. The implications across the capital structure, in the case of even one security defaulting, are obviously staggering, due to legacy limitations on what securities can and can not be held in a given defaulted corporate issuer by many asset managers. However, whereas the distressed exchange is much less of a judgment call if one is familiar with Moody's approaches and criteria for evaluating these events, a minor addition to the terminology by Moody's could jeopardize the recently gaining significant popularity phenomenon of open market distressed buybacks. As Moody's says:

All formal debt exchanges and tender offers are candidates for distressed exchanges. Additionally, open market and bilateral negotiated purchases of debt are also possible candidates for distressed exchanges. While purchases and exchanges are typically voluntary transactions, they can have the effect of allowing the issuer to avoid a bankruptcy filing or missed payment and, therefore, constitute an event of default.

In evaluating exchange offers, Moody’s interprets the term "debt exchange" very broadly. For example, when distressed issuers restructure or amend bank loan agreements which have the effect of allowing the issuer to avoid a bankruptcy filing or payment default, such transactions will be classified as distressed exchanges.
And while one may have been forgiven to assume that this is merely posturing on the side of Moody's, the rating agency showed it was not bluffing when it assigned a rating of Limited Default to Hovnanian, following its presumed "debt exchange." From Moody's Hovnanian release:

Moody's Investors Service assigned a Caa1/LD probability of default rating ("PDR") to Hovnanian Enterprises, Inc. ("Hovnanian") following the company's disclosure in its most recent 10-Q filing that between October 31, 2008 and March 11, 2009, it repurchased approximately $368 million face value of senior unsecured and senior subordinated notes at substantial discounts to par. The open market transactions, considered together, constitute a distressed exchange and a limited default by Moody's definition. The LD designation signifies a limited default and also incorporates Moody's expectations of open market transactions at substantial discounts to par over the next twelve months.
Two months ago, Zero Hedge wrote about the incentives, most notably from a tax perspective, for corporate issuers to buy back their "distressed" debt after a proposal by Max Baucus was included in the stimulus bill, made it beneficial for companies to repurchase debt in the open market. The irony of Moody's action is that with one ill-crafted sentence it has the potential to undo the stimulus plan's tax benefit to corporate issuers.

In summary, CFOs of highly leveraged companies that still have substantial cash amounts on their books, will now have to sweat the trade off of purchasing their cheap debt in the open market, since any tax benefit of doing so (see the linked article) will be eliminated by the threat that Moody's may assume the company merits a Hovnanian-like treatment and downgrade it to Limited Default, this making it impossible for the company to even have hope of accessing the capital markets in the future.

One additional implication is that while hedge funds have recently been purchasing the distressed debt of companies that have enough cash to be "potential debt buy back candidates", these very hedge funds will now also be at a loss whether the management team of any particular company will have the incentive to do so going forward, thus eliminating the benefits of "frontrunning" the company in its secondary market repurchases. As this has been a major theme for HFs over the past 2 months, leading to outsized gains in very distressed debt purchases versus less risky tranches, the trade could unwind promptly leading to significant losses for credit funds who are left holding the bag. Sphere: Related Content
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Anonymous said...

On the bright side, it may give us some insight into the 'thought process' by which ISDA's new 'Determinations Committee' will decide CDS credit events on 'distressed exchanges' - and potentially narrow the basis (in certain names) in distressed land?

Anonymous said...

Actually - just went to - they have the Determinations Committee settled now...maybe worth some of your perfect and pithy sarcastic insight...LOL

(PIMCO, Primus, and L&G...hhmm)


Anonymous said...

thats a good idea. let Moodys, who cant decipher a AAA piece of paper form a worthless piece of mortgage trash, make important decisions. brilliant.

Cetamua said...

Given their abysmal track record as rating analysts, remind me again why is Moodys still in business?

Cui bono?

Anonymous said...

Charles Calomiris is trying to use religion to sell handouts to bankers and bondholders. He spoke at the NY Greek Orthodox Church and tries to dismiss rejection of such cronyism as "bitterness and jealousy". Calomiris has a worse political ear than Larry Summers, the alleged CDO salesman.

Anonymous said...

I'd like to second anon of 6:51pm and Francois' comments. Remind us again why Moody's, who once allowed the most worthless paper the distinction of AAA, is now the final arbiter of credit-worthiness? Seems like if it was in the interests of a corporate issuer to buy back its debt at distressed levels, and this advantage helped this business stay in business (and keep people employed), then it seems reasonable to allow the transaction without a downgrade? Am I missing something?

Keep up the good work Tyler. This is turning into a must-read for me (and others I'm sure) along the lines of Naked Capitalism, and Mish's blog. Thanks for the hard work.

Anonymous said...

anybody really going to care what Moody's says on the issue?