Wall Street Bets on Debt That Doesn't Exist

The Wall Street Journal

Fresh from Wall Street's alchemy labs: Credit derivatives tied to General Motors Co. (NYSE: GM - News) debt. The rub is, no such debt exists.

Banks and hedge funds are trading credit-default swaps, which make payments to holders of General Motors bonds in the event of a default. But GM canceled $40 billion of debt in bankruptcy and has pledged to cut its remaining $4.6 billion bank loan to the bone this year.

That is merely a technicality for the banks and hedge funds that have been actively trading the CDS.

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Banks, some of which have made loans to the car maker, have been buying the CDS even though it is unclear whether the contracts would cover their debts, according to people familiar with the matter. Hedge funds have been happy to sell the protection, which allows them to make bullish, or "long," bets on the auto maker.

For proponents, the existence of the GM swaps is a sign of a market at work. It also is a reminder of how credit-default swaps can be used as a way to speculate on a company's creditworthiness, rather than purely as a hedge against exposure to its bonds.

Lawmakers and regulators have blamed credit derivatives for exacerbating the financial crisis and helping bring down companies like American International Group Inc. (NYSE: AIG - News) and Lehman Brothers Holdings Inc. Investors who bought "naked CDS" to bet on the likelihood of default, rather than to hedge risk from other investments, are credited with worsening the liquidity crisis that gripped those financial powerhouses, prompting calls for tighter regulation of the industry.

"Sure, having CDS without debt looks odd, and people may balk because credit derivatives were at the center of the AIG collapse, but that doesn't change the fact that CDS prices are the de facto benchmark used to measure the state of the credit market," said Kevin McPartland, senior analyst at research firm TABB Group.

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About $750 million of GM credit-default swaps have changed hands since investment banks, including Barclays PLC (NYSE: BCS - News), Deutsche Bank AG (NYSE: DB - News), Goldman Sachs Group Inc. (NYSE: GS - News), started trading in December, according to traders of the contracts. Some are also trading the CDS in anticipation that the car maker, which exited bankruptcy protection in 2009, will one day issue bonds again.

"Investors that did all the work getting to know GM through its bankruptcy and IPO get to go 'long' the credit now through the CDS," said Jason Quinn, co-head of U.S. high-grade trading at Barclays Capital.

The good news for GM: trading in its CDS indicates that many view the car maker as a better bet than rival Ford Motor Co. (NYSE: F - News).

A Better Bet Than Ford?
Some hedge funds have been selling GM CDS and buying Ford CDS, traders said. They are betting that GM's perceived risk will decline relative to Ford as the taint of bankruptcy fades and focus shifts to its low debt and improving international business.

On paper, the so-called "pair trade" paid off. In December, buyers of GM CDS paid $348,000 a year to insure a notional $10 million of bonds for five years; protection on Ford cost $282,000, according to Markit. As of Thursday, the GM swaps cost $290,000 and Ford's cost $295,000.

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While neither car maker is expected to default anytime soon, hedge funds selling derivatives on GM without actual bonds could pose a theoretical problem.

When a company files for bankruptcy or fails to meet its interest payments, the market stages an auction to determine the value of the defaulted debt, and how to compensate the CDS holders.

The value assigned to the CDS relies on investors being able to buy and sell bonds in the open market, so it is problematic for the newly revived GM not to have any bonds outstanding.

'There Could Be a Problem'
"I would take it people are pretty confident that GM will issue bonds again at some point in future, but there could be a problem in the auction if there was nothing to deliver," said Matthew Magidson, chairman of the derivatives practice at law firm Lowenstein Sandler.

For now, GM wants to show investors—and American taxpayers—as trim a balance sheet as possible.

GM does have $4.6 billion of loans outstanding, but it has been repaying that at a rapid clip. GM Chief Executive Dan Akerson said on a conference call on Thursday he is aiming to reduce the company's debt further.

If the cost of protection on GM continues to trade below Ford, for example, GM should be able to sell bonds at lower yields than Ford. Ford's benchmark 10-year bond yields about 6% right now, up from 5.6% in January before the company reported fourth-quarter earnings below analyst expectations.

Write to Katy Burne at katy.burne@dowjones.com

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