"Looking better dead than alive.” Morticians boast of it. So do Mafia hit men. Now, it appears, holders of some corporate bonds are secretly putting their faith in that declaration. Because of a dubious kind of derivative, the credit default swap, certain owners of corporate bonds would rather see a company die than work its way out of its problems.
Two companies alleged to be possible victims of their own bloodthirsty bondholders are once-proud newspaper empires: Gannett, the largest newspaper chain, and McClatchy, the third largest. Both companies are burdened with entirely too much debt. But both claim they will survive their debt struggles.
But get this: Morningstar, the stock-rating firm, says that shares of Gannett — that in 2004 sold for $91.38 — are worth $2.00. At midday Monday they sold for $5.06. And McClatchy? Its stock sold for $76.05 in 2005. Morningstar says the fair value is $0 — nada. The debt is so high and business so bad that “management will eventually have to manage the company to appease creditors [particularly bondholders] at the expense of equity shareholders,” says Morningstar. “Given the priority claim McClatchy’s creditors have on its assets, we think shareholders are at risk of being left empty-handed.” On Monday the stock traded for 51 cents.
This alleged problem has San Diego overtones. The late Helen Copley had a strong aversion to debt. Her top executives ridiculed that stance and took on debt to make acquisitions. But before David Copley unloaded the Union-Tribune for a lowball price, the company peeled off its debt. The deal for Copley, which was basically for the value of real estate, might not have gone through if the company had been laden with debt. Although she almost certainly had never heard of credit default swaps or even derivatives, Helen Copley understood that debt is dangerous: creditors can kill.
Charles Brandes of Brandes Investment Partners, a San Diego money manager who built the county’s most expensive house (once said to be worth $60 million), believes in buying out-of-favor stocks. By late 2007, the firm owned 14.63 percent of McClatchy stock. It originally bought it at $44.50. The year before, McClatchy had taken on $2.5 billion in debt to buy Knight Ridder. At the time, McClatchy shares were selling above $50. “McClatchy overpaid for the Knight Ridder acquisition,” says Morningstar in a gross understatement. The Brandes firm as of March 31 owned only 3.11 percent of McClatchy stock — having taken a beating on its bottom-fishing adventure.
The Brandes firm once owned 11.25 percent of Gannett, having bought in between $53 and $58. The stake is now down to 9.72 percent, but Brandes is still the largest institutional shareholder of Gannett. The firm also made bad bets on Freddie Mac, the Royal Bank of Scotland, Ford, General Motors, Kodak, and the former Washington Mutual and Countrywide Financial. Charles Brandes’s money-management firm had $111.6 billion under management at the end of 2007. After this year’s first quarter, the total was down to $33.3 billion, as the firm consistently underperformed benchmarks such as the Standard & Poor’s 500.
A credit default swap is like bond insurance. The buyer of a bond purchases this coverage by promising to pay regular premiums to another party (say, an insurance company, pension fund, or hedge fund), which, in turn, agrees to pay for losses in the event of bankruptcy, restructuring, or default. Credit default swaps are clearly insurance and from the beginning should have been regulated by states. Had that happened, the current financial crisis may have been softened. But authorities wanted swaps to be free of regulation. American International Group, the big insurer, got into trouble by guaranteeing too much corporate debt. When failures started tumbling in a domino effect (which American International should have foreseen), the government felt it had to bail American International out.
In a comprehensive article June 19, Richard Morgan of TheDeal Magazine described the pickle that Gannett got itself in. The company’s debt obligations fall due within three years. Gannett should have stretched out the maturities to, say, ten years. An inordinately large number of Gannett bondholders protected themselves with credit default swaps. In April, the company offered bondholders significantly higher yields if they would agree to lengthen maturities. But not that many took the bait.
“Gannett as we know it will be lucky to last through 2011,” wrote Morgan, noting that in February, Moody’s Investors Service cut the company’s debt rating to junk. The company has to raise $400 million between now and mid-2011. One bond expert told Morgan, “Frankly, many of their bondholders would rather they default” because of the insurance those bondholders have. Gannett says it has the capacity to pay its debts, but another analyst says, “Bondholders are saying that they’re hedged and that they basically want the company to die.”
McClatchy’s situation is similar. Standard & Poor’s rates its debt at CC, which is as low a junk bond rating as you can have short of default. Credit analysts say it is at risk of defaulting by year-end. It has axed about a third of its employees and eliminated its dividend. Recently, the company asked bondholders to exchange their existing bonds for new notes. Few took up the offer. Forbes magazine figures that the bondholders would have had to accept 25 to 33 cents on the dollar. “Credit default swap contracts usually pay a full dollar,” explains Forbes. If the economy and the newspaper industry turn upward, McClatchy could make it, says Forbes. But bondholders don’t seem to feel that is a good bet.
MediaDailyNews says that the bondholders’ lack of interest in McClatchy’s bond exchange could be a good thing — “a signal that creditors don’t believe there is an immediate threat of McClatchy defaulting on its debt.” On the other hand, the bondholders “may have quietly arranged insurance for their debts in the form of credit default swaps, in which case, it would mean the opposite — that they believe a default to be likely and are hoping to collect more money on their default insurance.”
A big worry is that this economy is not showing signs of recovering. That could result in even more financial setbacks for newspapers, more corporate defaults, and more bond insurers getting into trouble. Then the bondholders might wish they had taken Gannett’s and McClatchy’s offers.