Inside running

Guambat's Stew has included previous bites of information suggesting that those in the know are frequently the first in the go in the credit default swap market (see here and here and, more generally, here).

Here's yet more informed information from Bloomberg on the uber-informed swap-monsters. Big kudos to Bloomberg for digging up the story and staying with it.


Credit-Default Swap Traders Anticipated Announcements of LBOs

Derivatives traders may be profiting from inside information on leveraged buyouts and other takeovers, a study by Credit Derivatives Research LLC suggests.

Credit-default swaps based on the bonds of 30 takeover targets, including four of the five biggest LBOs of 2006, rose before deals were announced or news reports said transactions were likely, according to the New York-based independent research firm.

The fluctuations in credit-default swaps based on the bonds of Austin, Texas-based Freescale Semiconductor Inc., Sara Lee Corp. of Chicago and San Jose, California-based Knight Ridder Inc. were highlighted by the report. The U.K.'s Financial Services Authority said in June it would monitor unusual trading on concern inside information is leaking from banks or securities firms privy to details about takeover talks.

"The evidence keeps building that there is a problem here," said Michael Greenberger, former director of trading at the Commodity Futures Trading Commission and now a professor at the University of Maryland School of Law in Baltimore.

"Evidence shows that CDS prices are widening before public rumor or news," said Tim Backshall, a strategist at Credit Derivatives Research in Walnut Creek, California, who conducted the study. "Whether it's insider trading or more informed selling is unclear. That could simply be a reflection of smart players in the market buying protection."

Credit-default swaps are financial instruments based on about $350 billion of bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default, and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.

The total face amount of contracts outstanding worldwide more than doubled in the past year to $26 trillion, outpacing the growth of all other derivatives markets since their creation less than a decade ago, according to the International Swaps and Derivatives Association, or ISDA.

There are contracts on more than 3,000 companies in the U.S., Europe and Asia as well as indexes that seek to replicate the risk of investing in everything from emerging markets to mortgage-backed securities.

For investors seeking to speculate on the creditworthiness of companies, the market is gradually replacing corporate bonds because the derivatives are less expensive and easier to buy and sell [and, thus, make it easier to buy more and thereby skew the systemic risk of the whole system]. They are created by banks such as JPMorgan Chase & Co. and Deutsche Bank AG [who then get another inside look at who is doing what in this unregulated "market"], and do not depend on companies to be issued.

The SEC says it has no direct supervision of trading, while the CFTC says it isn't responsible. ISDA, a New York-based trade group whose members include the largest credit derivatives dealers, said this month that they aren't aware of any instances of investors using the market to exploit inside information.

The U.K.'s Financial Services Authority said in a June newsletter that the credit derivatives market "is very difficult to police" in part because participants are less likely "to report suspicious behavior."

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.

ISDA this month issued a statement saying the industry [that is, ISDA's own constituents] has done an effective job policing itself, and that their "understanding is that the regulators have been quite happy with the way things are."

[And, the Big Sticks in "the industry" are doing an equally good job to make sure they whack any government hack who tries to get too close to their honey pots; see this and this, for instance.]

Credit-default swaps have become so useful in predicting takeovers that will hurt bondholders that a growing number of debt analysts are now monitoring derivatives prices as a way to watch for potential deals. [And, of course, to speculate on those deals, and this is one way the systemic risk gets skewed, as commented above.]

Private-equity firms this year have raised a record $300 billion of acquisition funds, meaning the credit-default swap market is on "a hair trigger now with LBO rumors,'' said Backshall. Almost any report of a company being a target of private-equity firms causes prices to "blow out," he said.