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Desperation ?



Todd and I debated about whether or not to post this column: it gets into nuances that many might not understand or think relevant. But I thought this situation important to illustrate three things.

First, it shows Wall Street to be extremely inventive and creative in overcoming any impediment in "making money". It also shows a willingness to stretch the rules to achieve an objective. Often this stretching can cause problems by building up risk where regulators have put in rules to avoid it (I don't think this case illustrates that in particular, but the general theme of it).

Second, it illustrates how a desperate company will be receptive to those ideas set forth. Perhaps management will take a course of least resistance in the short run in lieu of a more difficult path that is the right one.

Third, it shows that when people (in this case the hedge funds) are desperate to make money they will sometimes take ill-advised risks.

Calpine Corp. (CPN:NYSE), a power generation company still suffering from the remnants of the Enron collapse, sold $600 million in convertible securities yesterday morning (plus $180 million in straight debt). The deal was highly unusual because of some technical factors in the way it was executed. That desperation is illustrated by the creativity of the deal.

As we have discussed before, companies issuing convertible bonds to raise money don't sell them to traditional fundamental funds like they used to; 95% of these issues are now placed with hedge funds (like ours) that hedge the "stock risk" of the convertible bond by shorting an appropriate number of shares (remember since these bonds are convertible into common stock at a certain price, the buyer of the bonds is exposed to a decline in the stock price).

The problem in this case is that the troubled company has a huge short interest, so huge that traders cannot borrow the stock (almost the entire float of the company is lent out to short sellers). This is particularly troubling for a company that wants to issue a convertible bond: the buyers of the convertible short stock to hedge the "option" component of the bond. Without the ability for hedge funds to short stock, they cannot hedge the "stock option" component of the bond, and therefore there would be no market of buyers for the bonds.

For this purely technical reason (although this was caused by the fundamental problems of the company in the first place), the company could not raise money (the only alternative left was a much more expensive equity or pure bond issuance) and was in a pickle.

A solution was provided by a large derivative oriented bank. They went to the company and suggested that the company allow them to borrow treasury stock, certificates not part of the outstanding float of the company and therefore not normally borrowable.

That description is not quite accurate. You can borrow it but you must go through a complicated registration process (a loophole that the SEC did not close and that the bank cleverly took advantage of) that each hedge fund physically would not be able to do. So the bank stepped in and borrowed 90 million shares of this treasury stock from the company and then went through the registration process that would allow them, and only them, to short the shares into the marketplace.

The bank then went to each hedge fund and offered a "synthetic" short through a swap arrangement. Once the bank had lined up all the hedge funds to accept the short and to agree simultaneously to buy the convertible bonds on the deal, it shorted the stock to arranged buyers in a 90 million share block trade in the market, then swapped the real short synthetically out to various hedge funds.

I know I may have lost some of you in this process. The end result is this: CPN the company is lending treasury stock to the bank to short (a highly unusual arrangement); the bank is short stock and long swap (a riskless trade except for counter-party risk); and hedge funds are synthetically short stock through a swap; the hedge funds then used this synthetic short to hedge the convertible bonds that they bought yesterday morning on the deal.

So the deal was completed, but with much ancillary risks that may cause problems. The hedge funds are beholden to the bank, which controls all sides of the trade, to eventually unwind the swap. This is never a position a trader wants to be in; the bank could "hold them up" for an adverse price when the trade is taken off.

The bonds are currently trading down relative to where the stock is trading, so those hedge funds that participated (we did not) are already marked at a loss. I suspect the deal is a little sour because it was so forced.

Acts of desperation don't usually work out that well.

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