Skip to Content

Dangerous Manufactured Defaults May Soon Be A Thing Of The Past

March 26, 2019 Blog

A shady deal in 2017 between Wall Street behemoth Blackstone and Hovnanian Enterprises, a leading homebuilder, has shaken investor confidence in the markets.

These “manufactured defaults” occur when an otherwise solvent company deliberately defaults on its debt. Powerful investment firms are making big money by encouraging companies to miss bond payments they could otherwise make.

“The practice has eroded market confidence, triggered legal fights and led to scrutiny from regulators,” according to a recent article from Bloomberg News.

It’s no wonder investors think they system is rigged!

In 2017, one of the largest asset managers in the world, Blackstone’s GSO Capital Partners disclosed that it had taken out insurance on bonds issued by Hovnanian Enterprises Inc., essentially betting that the home builder would default on the debts, according to an article last summer in the Wall Street Journal.

Blackstone looked  bad in the transaction, according to the report. It offered Hovnanian a low-cost loan “and persuaded the builder to miss a small interest payment in exchange, which would trigger payouts on a $330 million in Blackstone credit insurance contracts and yielded the firm tens of millions of dollars, depending on market factors,” according to the Journal article.

“The insurance contracts Blackstone took out, known as credit-default swaps (CDS) , typically pay out when a company defaults, usually reflected in dire financial straits,” the Journal reported.  “But Hovnanian was healthy enough to pay its debts, so a default would be opportunistic.”

Such financial manipulation is why some investors remain fearful of the stock market, despite its historic ten-year bull run.  Who can investors trust when Wall Street fosters such clearly unethical behavior?

Following the Blackstone deal, hedge funds and the International Swaps and Derivatives Association (ISDA) industry group voiced concerns about Blackstone’s strategy, according to the Journal report.

Even the regulators got involved.  The Commodities Future Trading Commission (CFTC) “waged an unusual campaign to get Blackstone to unwind its bet on the credit-default swap”, according to the Journal.

Almost a year later, it looks like Wall Street may actually figure out a way to fix this dirty practice.

“Wall Street banks and hedge funds are closing in on a fix that they hope will clean up an $8 trillion portion of the derivatives market that’s gained a reputation for being one of the shadiest corners of finance,” according to the recent Bloomberg story.

After months of negotiation, titans including Goldman Sachs, JPMorgan Chase, Apollo Global Management and Ares Capital have agreed to a plan that’s intended to ensure that the manufactured defaults are tied to “legitimate financial stress, not traders’ derivative bets,” according to Bloomberg.

The ISDA may propose the overhaul shortly.

The proposal would affect credit-default swaps (CDS), financial instruments that contributed to the 2008 financial crisis that insure against a bond issuer’s bankruptcy or failure to pay.

“If enacted, the changes would be among the biggest to the CDS market in years,” according to Bloomberg. “The new terms would lay out that a company’s failure to make a bond payment must be tied to its credit worthiness.”

ISDA’s decision to clamp down on this practice is a recognition that “manufactured defaults”  might be deterring some investors from entering the market. In addition, the industry wants to show global regulators that it can address the problem on its own to stave off stiff rules and beefed up CFTC oversight.

As with insider trading, every time investors see what looks like a rigged market or investment fraud, investor confidence diminishes.

Thankfully, CFTC and ISDA have stepped in during this instance. Regulators clearly need to be more proactive to prevent these types of transactions from happening again. Investors are counting on it.

Zamansky LLC is a New York law firm which represents investors in court and arbitration cases against securities brokerage firms and issuers.  The firm may represent investors in cases against companies mentioned in this blog.  Zamansky LLC also represents investors in arbitration cases against UBS and other brokerage firms regarding Puerto Rico bonds and UBS closed end bond funds and other investments.