By Shannon D. Harrington and John Glover
October 10, 2006
Bloomberg
SourceOct. 10 (Bloomberg) -- While Apollo Management and Texas Pacific Group were in supposedly secret talks to acquire Harrah's Entertainment Inc. for $15.1 billion, the takeover already was a done deal in the market for credit-default swaps.
Seemingly omniscient derivatives traders also determined that Kohlberg Kravis Roberts & Co., Bain Capital LLC, Merrill Lynch & Co. and Thomas Frist would buy HCA Inc. in the weeks before a $33 billion leveraged buyout of the hospital operator was announced. And they did the same thing two weeks before Anadarko Petroleum Corp.'s $21 billion agreement to buy Kerr- McGee Corp. and Western Gas Resources Inc. The debt and equity of these companies barely fluctuated when the price of credit- default swaps based on their bonds climbed as much as 40 percent.
Now that the suspicion of insider trading is increasing, regulators, who have had little to say about imposing rules on the $346 billion of unregistered credit-default swaps, may be forced to increase control over Wall Street's hottest and darkest market.
``In a market that is completely opaque, all sorts of abuses are made easier,'' said Michael Greenberger, former director of trading at the Commodity Futures Trading Commission, which regulates U.S. futures trading. ``The temptation to make money, in a way that would be unacceptable in a regular market, is just too great,'' said Greenberger, a professor at the University of Maryland School of Law in Baltimore.
No one is sure who has oversight of credit-default swaps, financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They're part of the explosion in derivatives, or contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather.
`Needs More Oversight'
The International Swaps and Derivatives Association, or ISDA, says the industry can police itself. The Securities and Exchange Commission says it has no direct supervision of trading in credit derivatives. The CFTC says it isn't responsible. Only the U.K.'s Financial Services Authority said it plans to watch for unusual trading patterns.
``What I find oddest is there has been very little forward movement in people admitting'' that insider trading is going on, said Jeff Lenamon, who trades credit-default swaps at Diversified Credit Investments in San Francisco. ``It needs more oversight.''
Pacific Investment Management Co., manager of the world's biggest bond fund and a unit of Munich-based insurer Allianz AG, started warning about the potential for abuse four years ago.
`Betraying and Destroying'
Chris Dialynas, a managing director at the Newport Beach, California-based firm, wrote a report in 2002 calling for the Federal Reserve and regulators to check whether banks were using private information to reduce their loan risk through credit- default swaps, which he said threatened to undermine confidence and curb trading in fixed-income markets.
``Credit-default markets are the mechanism within which friendly commercial bankers and others privy to inside information can profit by betraying and destroying their clients through the use of inside information,'' he wrote at the time.
Two years ago, industry groups including ISDA published recommendations for banks to erect internal ``walls'' to prevent information from leaking to their trading floors. Those efforts failed, Dialynas said last week.
``They didn't have an audit or surveillance mechanism included'' in the guidelines, Dialynas said. ``The problem is the cats that are running around are a lot smarter than the people trying to catch the cats.''
`Significant' Evidence
A London Business School study last year of 79 North American companies from 2001 to 2004 found ``significant'' evidence that contracts were moving ahead of news that could affect credit quality.
The rise in the number of hedge funds making loans to companies and protecting their bets with derivatives may be opening holes allowing information to get out, said Timothy Johnson, one of the study's authors. Hedge funds are private pools of capital that allow managers to participate substantially in the gains on investments made on behalf of clients.
``If you want to get access to information private banks have, you go and buy a piece of a bank loan,'' said Johnson, now an associate professor of finance at the University of Illinois at Urbana-Champaign in Champaign, Illinois.
Hedge funds account for 32 percent of credit-default swap sellers and 28 percent of buyers, up from 15 percent and 16 percent in 2004, according to a British Bankers' Association report last month. They are second to banks in each category. Pension funds and mutual funds make up 7 percent of the sellers and 4 percent of the buyers.
`Real People'
``This is a market in which endowment funds and pension funds are investing,'' Greenberger said. ``Real people who need sound investments are being affected by this.''
Credit-default swaps based on the debt of more than 3,000 companies trade daily, according to Markit Group Ltd. in London. They are created by banks rather than sold by companies.
JPMorgan Chase & Co., Deutsche Bank AG and Goldman Sachs Group Inc. are the most frequent traders of credit derivatives, a Fitch Ratings survey published last month showed. The top 10 firms accounted for two-thirds of the trades in 2005.
Goldman Sachs takes the issue of internal controls of credit derivatives ``very seriously,'' said Stephen Hickey, global head of loan trading at the firm in New York. Deutsche Bank has ``rigorous wall-crossing procedures'' to prevent insider trading, Stephanie Smart, a spokeswoman, said in an e-mail. A JPMorgan spokeswoman, Brooke Harlow, didn't return calls for comment.
Clear Intentions
``Commercial banks, normally in possession of non-public information, have used the secondary market to risk-manage their loan portfolios for many years,'' Hickey said. ``Today, as institutional investors enter the market, they must be very clear on whether they are trading in possession of public or private information.''
Conceived to protect bondholders against default, the contracts pay a buyer the face value of a bond in exchange for the security should a borrower fail to meet its obligations on time. The agreements typically expire after five years.
A rise in the price of a credit-default swap signals deterioration in the credit quality of the company issuing bonds; a decrease means the opposite.
Growth in credit-default swaps has outpaced all other markets for derivatives since their creation less than a decade ago. The total notional, or face, amount of contracts outstanding worldwide more than doubled in the past year to $26 trillion, ISDA said in a report last month. The underlying value of contracts outstanding rose from $182 billion, the Bank for International Settlements in Basel, Switzerland, estimated. They are supplanting the bond market as the best gauge of the creditworthiness of companies.
Early Signals
The credit derivatives market often picks up signals first ``just because that's where the liquidity is,'' said Jonny Goulden, head of credit derivatives research at JPMorgan in London.
Evidence of insider trading in the contracts increases as the total number of banks involved in providing financing for takeovers grows, according to the London Business School study. There were 242 institutional investors including hedge funds in the loan market last quarter, compared with fewer than 100 in 2002, according to Standard & Poor's.
``The more there were of those, the more credit-default swaps tended to react like Harrah's and move before the bonds and stock,'' said Johnson, who wrote the report with Viral Acharya.
Harrah's Trading
Buyers of credit-default swaps tied to Harrah's, the world's biggest casino-operator by sales, made as much as 40 percent in the two weeks ending Sept. 29 as the contracts based on $10 million of bonds jumped to $112,000 from $80,000, according to data compiled by Credit Suisse. The Las Vegas-based company said on Oct. 2 it received a leveraged-buyout offer from Apollo in New York and Dallas-based Texas Pacific, pushing the price of the credit derivatives to a record $250,000.
LBOs cause prices of credit-default swaps to soar because private-equity firms typically make the companies they're buying borrow about two-thirds of the purchase price to finance the acquisition. Prices for contracts on the five biggest buyout targets this year more than doubled on average in the week after offers were announced, Credit Suisse data show.
S&P cut Harrah's credit rating to BB+, one level below investment grade, from BBB- after the bid was announced. Harrah's spokesman Alberto Lopez didn't return calls for comment.
`Seems Fishy'
``You certainly see movement that just seems fishy,'' Diversified Credit's Lenamon said. ``Harrah's was a good example. It's just kind of curious. All of a sudden someone says `LBO rumor,' and there's nothing on the business news, there's nothing anywhere, and you wonder how that kind information somehow flows into the credit market.''
Speculation that Harrah's was an LBO target surfaced on Sept. 27 when Briefing.com, a stock-analysis Web site, wrote: ``Hearing LBO chatter circulating.'' A report by New York-based fixed-income research firm CreditSights Inc. on Sept. 28 also identified Harrah's as a possible takeover target.
``The insider trading accusation is one which is sort of like the lawyer's comment: `When did you stop beating your wife?''' said JPMorgan's Goulden. ``It's difficult, once made, to convince people that there's not something there.''
Harrah's stock was little changed in the two weeks before the LBO announcement, rising to $66.43 on Sept. 29 from $64.51 on Sept. 15, compared with a 3 percent gain for the S&P Casino & Gaming Index. The shares had their biggest jump in eight years on Oct. 2, climbing 14 percent to $75.68, after the $81-a-share LBO offer was made public. In the two weeks ended Sept. 29, its $750 million of 6.5 percent notes due in 2016 fell to 97.89 cents on the dollar from 98.38 cents, according to Trace, the NASD's bond- price reporting system.
HCA Jumps
Credit-default swaps tied to Nashville, Tennessee-based HCA, the owner of the biggest U.S. hospital chain, rose to $180,000 on July 18 from $155,000 on July 11, a 16 percent surge, Credit Suisse data show. The Wall Street Journal reported July 19 that a group including Boston-based Bain, KKR in New York and HCA co- founder Frist had been negotiating to take the company private.
Meanwhile, shares of HCA declined to $43.29 from $44.01, and the company's $1 billion of 6.5 percent notes due in 2016 fell only about 1 cent on the dollar to 91.85 cents, pushing the yield up to 7.72 percent. In the two days after the Journal report, the shares surged more than 11 percent to $48.20, and the bonds tumbled to 87.23 cents.
HCA Spokesman Jeff Prescott declined to comment.
Anadarko Contracts
Contracts on Houston-based Anadarko's debt jumped to $34,000 on June 22 from $24,000 on May 31, Credit Suisse data show. Anadarko said June 23 it was buying Kerr-McGee and Western Gas. In the same period, Kerr-McGee stock slumped to $50.30 from $53.43, and Western Gas shares declined about 17 percent.
Following the announcement, shares of Kerr-McGee jumped 36 percent and Western Gas stock soared 46 percent. Credit-default swaps on Anadarko reached $58,000 on June 28.
Anadarko said in July that it received an informal inquiry from the SEC on possible insider trading.
John Coffee Jr., a professor of securities law at Columbia Law School in New York, said that the examination probably focused on equity options. A spokeswoman for Anadarko, Teresa Wong, said the SEC's ``questions were answered, and there's been no further communication.'' She wouldn't provide further details.
Monitoring Alerts
The Fed and SEC in Washington and the FSA in London last month issued a joint statement warning that risks posed by credit derivatives demand ``borderless'' solutions. They didn't address insider trading.
``Regulators don't seem to have controlled insider trading at all in the CDS market or in other markets,'' said Ian Spreadbury, who manages the equivalent of $2 billion in high- yield debt at Fidelity International in London.
The FSA's 2006-2007 business plan includes 10 million pounds ($19 million) for creating a computer system by July alerting it to ``unusual or suspicious transactions'' in securities including credit-default swaps.
``We need a system that gives alerts,'' Dilwyn Griffiths, head of market monitoring at the FSA, said in an interview. ``We're concerned with anyone who makes use of access to confidential information to trade financial instruments.''
The SEC can only monitor credit-default swaps trading indirectly, through its oversight of Wall Street firms, said Robert Colby, the agency's deputy director of market regulation. The Commodity Futures Modernization Act of 2000 excluded derivatives not traded on any exchange from the jurisdiction of the CFTC.
``We have no reason to think there are instances of insider trading,'' said ISDA spokeswoman Louise Marshall. ``Our understanding is that the regulators have been quite happy with the way things are.''
`Blogs' and Gossip
Credit-default swap traders use news services and Internet Web logs, or ``blogs,'' to alert them to gossip about companies, as well as software that picks up ``buy'' or ``sell'' signals across stock, bond and options markets, said Steven Mitra, a portfolio manager at LNG Capital, a London-based hedge fund.
``We clearly need immediate, greater disclosure,'' said Arthur Levitt, who was chairman of the SEC from 1993 to 2001 and is now a board member of Bloomberg LP, parent of Bloomberg News.
Credit-default swaps are traded ``over the counter'' or outside of exchanges, meaning there is no central place that records transactions or any authority to enforce rules. Stocks and futures trade on exchanges that also act as regulators.
The transactions are playing a bigger role on Wall Street. Goldman Sachs said in an SEC filing that it had $48.5 billion of assets in over-the-counter derivatives as of August, more than quadruple its holdings in exchange-traded contracts. A year earlier, it had $54.5 billion in OTC derivatives, compared with $8.39 billion in exchange-traded derivatives.
Lax Handling
Regulators led by the Federal Reserve Bank of New York in September 2005 said that Wall Street firms were lax in handling credit derivatives trading after discovering 150,000 unconfirmed or unsigned trades on credit-default swaps. They demanded banks clean up the mess, and the number of unsigned contracts declined 85 percent from last year, the New York Fed said Sept. 28.
Banks employ compliance officers to police trading and control access to private information. Greenberger at the University of Maryland says regulators also have to step in.
``We're approaching the tipping point,'' Greenberger said. ``There's going to have to be a reporting system. People should be able to look and see what's happening.''
To contact the reporter for this story: Shannon D. Harrington in New York at
sharrington6@bloomberg.net ; John Glover in London at
johnglover@bloomberg.net .
Last Updated: October 10, 2006 00:02 EDT