Over at Portfolio’s Market Movers, Felix Salmon picks up on an interesting point: Matt Wirz, the editor of debtwire, tells him that traders and speculators have been buying leveraged loans in the expectation – or rather, hope – that the loans covenants will be busted.
As Salmon points out:
If you’re looking at a company which has reasonably healthy fundamentals but which risks breaking its covenants just because the debt markets have seized up right now, then there’s a good chance you can make money on two fronts with this trade: the price of the bonds will rise in any case as the fundamentals of the company assert themselves and as the current dislocation passes, while at the same time the company will be forced to make extra payments for breaking the covenant.
The interesting thing is how that ties with this, posted on Thursday on FT Alphaville.
It’s about the a legal dispute between monoline SCA and Merrill Lynch – and specifically, how it is throwing up a lot of interesting questions about super-senior CDO tranches and control over defaulting CDOs. Central to it all is the detail around SCA’s allegation that Merrill “rushed” to sell senior CDO tranches when it became apparent SCA’s protection on them might not be worth all that much.
And crucial to selling those tranches to new third parties, appears to be Merrill’s promise to the buyers that the notes carried “control rights”. SCA disputes that, and says the control rights belonged to them (via the CDS they wrote on those notes).
Why would AAA-tranche CDO investors be bothered in control rights? Because, those control rights would give them the option to liquidate or accelerate the CDO when it breached its “event of default” trigger. And, if you accelerated or liquidated the CDO, being an AAA noteholder you would, in all likelihood, get most of your money, even if the CDO’s collateral was woefully underperforming.
Just as with the leveraged loans Salmon mentions, that, then, is quite a good deal, if you bought the paper from a desperate bank selling at distressed prices.