In a recent post we demonstrated how the Willow Fund’s purchase of credit default swaps evolved from hedging a portion of its distressed debt to swamping the portfolio with enormous short positions in distressed debt. In this post, we explain why the Willow Fund’s use of credit default swaps was inconsistent with its repeated disclosures that:
… The Fund may use a variety of special investment techniques to hedge a portion of its investment portfolio against various risks or other factors that generally affect the values of securities and for non-hedging purposes to pursue the Fund's investment objective. These techniques may involve the use of derivative transactions, including credit default swaps.*A Credit Default Swap (“CDS”) is a contract that transfers the risk of a credit default on a given bond or portfolio of bonds. The company that issues the bond is called a reference entity. A CDS contract involves two parties, a party that wishes to buy insurance and a party that wishes to sell insurance. The buyer of insurance agrees to pay fixed periodic payments to the seller of insurance. The fixed payments are called CDS premiums. In exchange for the CDS premiums, if the bond issued by the reference entity defaults, the seller of insurance must purchase it from the buyer of insurance at face value or make a cash settlement payment equal to the difference between the defaulted bond’s face value and its market value.
Figure 1 Credit Default Swap Cash Flows
If perceived credit risk increases, CDS premiums which are the price of insurance against default losses will increase. Once a CDS contract is entered into and the CDS premium for that contract is fixed, if CDS premiums increase the credit protection buyer (seller) will have a mark-to-market gain (loss). Conversely, if at-market CDS premiums decrease because the credit risk decreases, the credit protection buyer (seller) will have a mark-to-market loss (gain).
Like other swap contracts, credit default swaps do not normally require an upfront exchange of the contract’s underlying exposure or “notional value.” CDS contracts are thus inherently leveraged investments. For example, an investor with $100 in cash could theoretically buy or sell a CDS contract with an arbitrarily large notional amount, e.g., $100,000. Although the investor doesn’t need to have the notional value to buy or sell the contract, he does have to deposit sufficient cash to cover any daily declines in the contract’s market value.
Using CDS to Hedge
Now, back to what the Willow Fund said it was doing with credit default swaps. First, the Fund said it might use CDS to “hedge a portion of its investment portfolio”. The Fund could hedge some of the credit risk out of its portfolio of distressed debt by buying CDS. Prior to 2007, the Willow Fund bought CDS contracts with total notional values that varied but were less than its portfolio of distressed securities. Since the CDS contracts the Fund owned would likely have gains if its portfolio of distressed securities suffered losses, the Fund’s pre-2007 use of CDS hedged a portion of its investment portfolio.
The September 30, 2007 N-Q (downloadable by clicking here) provides a good example of the Willow Fund’s use of CDS to hedge. Table 1 is an excerpt from the September 30, 2007 N-Q. The Fund had $465 million of Net Assets and purchased credit default swaps with $125 million in notional value. By doing so, it hedged or cancelled the credit risk in $125 million of its distressed debt portfolio.
The CDX HY8 entry warrants a little more discussion. CDX HY is a series of indexes of credit default swaps on high yield corporate debt much as the ABX is a series of indexes of credit default swaps on subprime mortgage backed securities. CDX HY 8 was the eighth in the series which has now grown to over 20 rolling high yield CDS indices. The “November 2008 Markit Credit Indices, A Primer” can be downloaded by clicking here. CDX HY 8 first calculated and reported by Markit in March 2007. A Markit fact sheet (download factsheet by clicking here) lists the 100 equally weighted high yield reference obligations underlying CDX HY 8. Being long the CDX HY contracts, allowed the Fund to hedge out market-wide changes in distressed debt credit risk and isolate the credit risk idiosyncratic to its holdings.
Using CDS to Invest
The Willow Fund also said that it could use credit default swaps “… for non-hedging purposes to pursue the Fund's investment objective.” By selling credit default swaps and purchasing low risk collateral equal to the notional value of the credit default swaps on distressed sold, the Willow Fund would have created a synthetic long position in the distressed debt referenced in the credit default swap. According to its SEC filings, the Willow Fund was always a buyer, not a seller, of credit default swaps and so didn’t use credit default swaps to implement its investment strategy.
Using CDS to Speculate and to Leverage
As a buyer of CDS contracts, the Willow Fund was shorting credit risk. Initially it was shorting less credit risk than it had in its portfolio of distressed securities and so could be said to be hedging. Starting in 2007 though the Willow Fund was short much more credit risk through its CDS portfolio than it was exposed to in its securities holdings. From 2007 onward the Willow Fund was using the CDS contracts not to hedge or to implement its investment strategy but to speculatively short distressed debt.
The Willow Fund chose a lousy time to deviate so dramatically from its disclosed investment strategy and massively short distressed debt. The blue bars in Figure 3 illustrate the Willow Fund’s CDS notional values. The red line is the at-market CDS rate on high yield debt. The Willow Fund had started speculating with CDS by late 2007 and dramatically increased its distressed debt short exposure from $500 million to $2.4 billion when the generic 5‑year HY CDS rates were between 800 and 1500 basis points. The Fund kept most of this exposure as HY CDS rates fell back below 500 basis points. The Fund was short $2 billion of distressed debt as credit risk declined and distressed debt prices recovered. These losses and the Fund’s 15-to-1 or greater leverage taken on through the CDS bets caused investors to lose nearly $300 million.
Figure 3 Willow Fund Bets Against Distressed Debt With Enormous Leverage as CDS Rates Fall
The temporary increases in CDS rates in early 2010 and in late 2011 explains the profits the Willow Fund had in the first half of 2010 and the second half of 2011, only temporarily interrupting the calamitous losses it suffered from June 2007 to December 2012.
The Willow Fund did not disclose this change in its use of CDS contracts until after it had suffered over $210 million in losses while speculating with CDS. In the 2010 N-CSR filed with the Securities and Exchange Commission on March 11, 2011 the Fund stated “... the Fund entered into credit default swaps for speculative purposes as a "protection buyer".” The fifteen previous annual and semi-annual reports said only stated “... the Fund entered into credit default swaps as a "protection buyer".” That is, 65% of the losses resulting from the Willow Fund’s explosive use of CDS contracts occurred before it even hinted in its SEC filings that it was no longer hedging or investing but was speculating with CDS.
Figure 4 Willow Fund Partially Discloses Speculation After Three Years and $200 million in Losses
*This language is repeated verbatim in all the Fund’s Annual and Semi-Annual Reports. See, for example, the 2009 N-CSR here.