Much can be said of the moral argument in making money on someone else’s failure. The public does not like the idea that someone can make money from someone else’s loss, hence the ban on short selling following the financial crisis.
I can see where people might have a problem with the idea.
If I were to short sell Hewlett-Packard’s stock, you might say that my profits are somewhat correlated to the number of job losses at HP over the next few years. That does not resonate very well with people. I can understand that.
Forcing Failure for Profit
Previously I wrote about Six Flags and how it is one of the odd businesses that should never go into bankruptcy. Of course, we know that it did go under because management was acquiring other parks and incurring debt burdens that were too large and too expensive to be repaid.
Six Flags is an interesting case in making money from other people’s misery. After coming to the conclusion that it was overburdened by debt, it did what all companies try to do: negotiate with creditors for new terms to avoid bankruptcy. At one point, Six Flags offered to give up 85% of its equity to unsecured debt holders to avoid the bankruptcy courts.
This never happens, ever. This deal was rich – analysts could not believe that Six Flags offered up 85% of ownership to unsecured debt owners when unsecured debtholders would stand to receive 10% of the company in a bankruptcy court.
Unsecured lenders did what any
rational crazed lender would do: they shot down the plan. It was extraordinary – no one with their heads on straight could figure out why. Why would unsecured debt holders turn down 85% for 10%?
Last Man Standing
There was one debt owner standing in the way of debt negotiations. It is rumored that the holdout was Fidelity, which owned Six Flags debt in one of its mutual funds. Why would Fidelity act in a way that would hurt its investors?
Why would Fidelity turn down 85% for 10%?
Fidelity had a side bet. It purchased a credit default swap, insuring the Six Flags debt that it owned. That credit default swap would reimburse the company for its debt investment if Six Flags defaulted. The terms of the contract invariably stated that default was bankruptcy, and bankruptcy only.
Thus, Fidelity and its mutual fund shareholders had more to gain from the failure and bankruptcy of Six Flags than from the reorganization talks. Restructuring would not be recorded as a technical default, and thus Fidelity could not claim on its very valuable insurance – a credit default swap.
Six Flags’ other unsecured debt holders were screwed by Fidelity’s strong arm. Fidelity’s mutual fund investors made out like bandits, forcing bankruptcy instead of reorganization, costing the firm millions of dollars in legal fees while pitting one investor against several others in what is one of the most mystifying bankruptcies in history.
Fidelity stood on uneven ground with other investors. It owned enough debt that it could block any reorganization talks. It was also hedged, perhaps asymmetrically, to the extent that it would make more by forcing a negative outcome than a positive outcome. Fidelity pulled the “I have mine, so screw you!” card, working out a better deal for itself while punishing all the other capitalists who joined it in financing Six Flags.
Solving this Complicated Problem
We need more clarity into the derivative market. Investors purchased Six Flag’s debt under the assumption (a reasonable assumption) that all debt holders were in the same boat, and that any other bond holders would share an interest in restructuring should it happen.
When investors buy a debt obligation they expect that they will have more rights than shareholders. They expect that, should the firm they fund go broke, they will have a chance to renegotiate terms. There are expectations built in to the price of a debt obligation.
No one who held Six Flags’ debt expected that another bondholder held a trump card. No one thought that Fidelity’s substantial bond holdings would be used against owners of the same or similar obligations.
This information never made it into the market. To this day, we still don’t know who the holdout firm was, or why they held out. It’ll never be known except to those closest to the deal because derivatives trading is done in secret. Any reasonable person comes to the conclusion that it was a derivatives deal by Fidelity…it’s 99.9999% certain, but we can’t be 100% sure.
Someone made a lot of money on someone else’s failure. But until an analyst, portfolio manager, or broker steps forward in what would be a career-ending move, we’ll never know who or just how much they made.