The default option

Newspapermen don't come any grittier than Al Neuharth. Even today, at 85, the USA Today founder remains to many the public face of Gannett Co. His staying power reflects both his provocative opinions, which USA Today continues to feature in a column called "Plain Talk," and his corporate contributions, as president or chairman and titles in between, to Gannett's glorious run from 1970 to 1989. That power was still much in evidence on April 28, when a white-suited Neuharth stood before a microphone inside Gannett's McLean, Va., headquarters to close out the company's annual shareholder meeting.

After admitting he had never asked a question at such a gathering, despite having attended all 42 of Gannett's annual meetings, Neuharth acknowledged tough times for every constituency of the country's largest newspaper publisher. "[But] it's important to recognize that this is not the end of the world," he said.

"In fact, I believe the moves have been made that really position this company extremely well for the inevitable economic upturn and for the boom that I believe is sure to come in the news and information business in this digital age."

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Unmentioned were the moves not made -- moves that could have ensured Gannett's participation in the digital-age boom that Neuharth envisions for the news and information business. Although not entirely removed from challenges confronting the industry, these moves would have been specific to the company. They would have conserved capital through a much earlier dividend cut and, more importantly, staggered credit obligations so they fell due within 10 years, say, instead of three. As a distressed-debt expert puts it: "They could have taken their capital structure and pushed maturities so far out into the stratosphere that their debt situation isn't relevant today. And they could have easily done that not very long ago."

Now, financial sources contend, it's too late. Because of the credit crisis, an unfortunate bunching of credit maturities and a debilitating number of so-called negative-basis trades featuring credit-default swaps -- all in addition to the industry's secular and cyclical downturns -- Gannett as we know it will be lucky to last through June 2011. "They painted themselves into a corner," the distressed-debt expert says of Gannett management. "They have to raise more than $400 million between now and the middle of 2011 in a market where, frankly, many of their bondholders would rather they default."

Bondholders who wish the issuer of the securities they're holding to default were unheard of when Neuharth stepped down as Gannett's chairman. But credit-default swaps, or CDSs, are rapidly turning some bond investors into a powerful if perverse presence. The perversity originally stemmed from an innocent desire of risk-averse bondholders to protect themselves against losses on certain securities. CDSs, a mid-1990s creation of J.P. Morgan & Co., sought to provide this protection through private contracts: A bond buyer agrees to pay premiums for a period of time to a seller, who in turn agrees to pay for losses created from a credit event (bankruptcy, restructuring or default) occurring to the issuer of the bonds.

CDSs, which began the decade as a $900 billion market, ended last year with a notional value of $42 trillion. And even though that was down from the notional peak of $57.9 trillion that the Bank for International Settlements recorded for year-end 2007, CDSs still rank among the fastest-growing types of financial derivatives. They've also expanded beyond their original purpose as hedging vehicles for the risk averse -- an expansion that's irrefutable once the $42 trillion CDS market is compared to the $25 trillion market for outstanding corporate bonds, municipal bonds and structured investment vehicles that CDSs were designed to reference. The disparity suggests that at least $17 trillion of outstanding CDSs aren't hedges at all but rather speculative bets on the possibility of a credit event between parties who don't own any of the underlying securities.

This type of betting has already been implicated in playing unsavory roles in the bankruptcies or bailouts (or both) of American International Group Inc., General Motors Corp., Idearc Inc. and Lehman Brothers Holdings Inc. Now it shapes the case of Gannett, a company that ended its first quarter with net debt of only $3.7 billion. However, according to the Depository Trust & Clearing Corp., the gross notional value of outstanding CDSs referencing Gannett is $30.9 billion. (This number reflects the par amount -- as opposed to the market price -- of credit protection bought against the company's debt, as calculated on a per-trade basis. For example, protection on $10 million in bonds between a buyer and seller is calculated as one contract with a gross notional value of $10 million, rather than as two contracts worth $20 million.) Walt Disney Co., by comparison, has $14.7 billion in debt, nearly 4 times as much as Gannett. Yet the gross notional value of Disney's outstanding CDSs clocks in at $22.6 billion, or 27% less than Gannett's.

A comparison of net notional values is just as telling: $2.3 billion for Gannett versus $1.8 billion for Disney. (These numbers represent the sum of net protection obtained by CDS buyers or, conversely, the sum of net protection sold by CDS sellers. Consider a party that buys $200 million in CDSs referencing Gannett but in other trades sells $180 million in Gannett CDSs. The party's contribution to Gannett's net notional position of $2.3 billion is $20 million.) This comparison warrants citing each company's total debt again: For Gannett, net notional CDSs account for 62% of its $3.7 billion total and 131% of the nonbank debt that Gannett CDSs actually reference; for Disney, CDSs represent only 12% of its $14.7 billion total.

How Gannett became such a CDS magnet is alarming, given that at its annual shareholder meeting in 2008, chairman, CEO and president Craig Dubow called its balance sheet "the best in our industry." Analysts generally agreed, citing a debt ratio of about 2.1 times Ebitda, compared with an average of 4.4 times for Gannett's publicly traded peers. In calendar 2008, however, the company's Ebitda declined 26%, to $1.5 billion. And for 2009, the consensus forecast calls for another Ebitda slide -- a 38% decline this time -- to $922 million. "It's very hard to run the same capital structure on half the cash flow," a source says in reference to the two-year Ebitda drop of 54% projected for Gannett.

The deteriorating fundamentals have not been lost on the credit-ratings agencies. After a series of rating reviews and declines, Moody's Investment Service slashed Gannett's credit status to junk in February. It followed the downgrade in April by announcing another review to investigate whether, among other things, "Gannett may be required to amend the 3.5x maximum senior debt-to-Ebitda covenant in its bank credit facilities by the end of 2009 to avoid a covenant violation."

Declarations of this sort not only fan CDS demand but, as the derivatives gain value and odds of a credit event appear to increase, potentially pit bondholders who have bought protection against management. "Bondholders would be crazy to give up their CDS protection while they wait and see what happens," one hedge fund manager says. Such conflicts can upend even historically healthy relationships, another source says, taking hedged bondholders to "a place where all they want is a credit default."

That so many Gannett bondholders have reached this point of no return wasn't fully apparent until the company tried extending some note maturities earlier this year. A private exchange offer, announced April 7, allowed eligible holders to exchange two tranches of "old notes" (the first paying 5.75% and due June 2011; the second paying 6.375% and due April 2012) for two tranches of "new notes" (the first paying 10%, including a $30 early-participation payment, and due 2015; the second also paying 10%, including a $30 early-participation payment, due 2016).

Gannett also guaranteed new notes by the same subsidiaries that had already provided guarantees to its banks under revolving-credit and term-loan agreements.

Despite the rich upgrades and guarantees, not to mention two extensions of the early-participation date, only 26% of both tranches tendered before the offer's May 5 expiration. And of the nearly $500 million in 5.75% notes due June 2011 -- Gannett's next maturity -- only 13% tendered. This means $432 million of the 5.75% notes will still be due June 2011, uncomfortably followed by the maturity of a $280 million term loan the next month.

That's a lot of coin -- $712 million -- before even addressing the $2.8 billion Gannett has due in the first half of 2012.

Gannett executive vice president and CFO Gracia Martore tried putting a good face on the exchange, claiming in a brief statement to be "very pleased with the results." And when asked to elaborate, a company spokeswoman is almost as brief. "We've said what we're going to say on this in our [Form 10-Q], during our earnings call and in the releases connected to the debt swap," she says. "Between our revolver and our free cash flow, we have the capacity to pay our debts." Both responses strike more than a few observers as naive or disingenuous for missing the real message of Gannett's poorly tendered exchange. Says one such observer, who considers the scant participation the consequence of an aggressive play in negative-basis trades, "Bondholders are saying that they're hedged and that they basically want the company to die."

A negative-basis trade locks in profits by exploiting differences between the CDS spread and the bond spread for the same, similar or identically referenced securities. The first of these spreads, the CDS spread, represents the premium a trader is willing to pay for protection on a particular bond. It's market-determined as a practical matter but purports to be mathematically reproducible through a calculation of cash flows. That is, in math terms, the CDS is the internal rate of return balancing the present value of expected premium payments with the present value of expected loss payments.

The second component of basis, the bond spread, is the interest rate on the corresponding bond, discounted by a risk-free rate on a similar-term security, such as a Treasury.

Because basis is the difference between the CDS spread and the bond spread, a negative basis requires the CDS spread to be less than the bond spread. A negative basis also signals that the bond is relatively cheap and the CDS is relatively expensive. This sets up an arbitrage for a trader who goes long by buying the relatively cheap bond and short by buying the relatively expensive CDS. Then, with the basis inevitably narrowing as bond and CDS move toward maturity, the trader can sell his once-cheap bond at a relatively higher price and cover his short at a relatively lower price. It's risk-free, too, presuming the trader's CDS returns enough in the event of a default to compensate for the bond's inability to pay back at par.

The credit crunch has produced one of the richest times in history for negative-basis trades. A J.P. Morgan Securities Inc. basis chart, featuring average high-yield bonds and the CDSs referencing those bonds, turns negative in March 2008 and bottoms out at about negative 700 basis points near the end of the year. Although basis trading is technically the play of an arbitrageur, not all traders engaged in it remain true to that worldview. Even hedge fund managers are given to trusting their intuition as much (or more) as their spread sheets, especially if they sense additional profit can be made by staying in position. As a member of their ranks explains: "If hedge funds can make more holding out, they'll hold out. It's their nature."

That so few traders participated in Gannett's exchange suggests they are indifferent to an insolvency or expect better terms to be forthcoming. Either way, they're in no hurry to work out maturities.

Basic math indicates why: A CDS referencing Gannett debt, according to CMA DataVision, costs 14.5% up front plus 500 basis points running. This translates into a downpayment of $1.45 million plus $500,000 a year for each $10 million of protection. Let's assume a trader bets that Gannett can last to June 2011, when the $432 million of 5.75% notes come due, but no longer. His CDS cost for the period would total $2.45 million ($1.45 million plus two years at $500,000 apiece).

If the trader bets correctly, meaning a default does occur, let's further assume a historically defensible recovery rate of 30%. The trader's return using this assumption, unadjusted for time, would be 186% on a two-year investment. (A real settlement would most likely require an auction of the defaulted bonds to determine their post-default value, after which the CDS seller would pay the difference between the par value of the bond referenced by the CDS and its auction-determined, post-default value.) But that's not all. While waiting for the credit event, the trader, if hedged, would continue to receive interest payments on his underlying 5.75% note. The Financial Industry Regulatory Authority now has the note priced at 76, to yield 21.2%.

This win-win situation has fueled what University of Texas Law School professor Henry Hu calls the empty-creditor phenomenon. An empty creditor may have started out as a traditional lender by making loans and buying bonds. But somewhere along the line, he began supplementing his basic credit transactions with CDSs or other instruments. These additional instruments, Hu writes in a recent opinion piece in The Wall Street Journal, "now permit a creditor to avoid any actual exposure to financial risk from a shaky debt -- while still maintaining his formal contractual control rights to enforce the terms of the debt agreement, and his legal rights under bankruptcy and other laws."

Hence, the ability of the empty creditor to render himself less economically sensitive to the fate of his debt issuer, who in earlier eras he would have wanted to stay out of bankruptcy. "Let's say a creditor lends $100 million but then buys $200 million in CDS protection," Hu says. "In this extreme version of an empty-creditor pattern, the lender would actually have an interest in seeing his borrower fail."

What's more, he may even be able to exercise his creditor rights to advance his CDS agenda. "If you're a borrower on the ropes," Hu continues, "you're used to negotiating with your creditor as if he has a really big stake in your survival. Well, that may not always be true today."

Hu coined the "empty-creditor" term as a theoretical construct in 2007 and, since then, has co-authored articles that refine the analysis.

But he didn't have his aha! moment until AIG disclosed in March that it had used $7 billion of its government loan to satisfy obligations to Goldman Sachs Group Inc. It turns out the disclosure followed a pronouncement by Goldman six months earlier that its AIG exposure was "not material." On subconsciously connecting the dots, Hu snapped awake early one morning with the realization, "If this pattern was occurring in one of the defining moments of the financial crisis, it's difficult to believe that it's not happening elsewhere."

Hu's empty-creditor concept isn't meant to present acknowledged practitioner Goldman and quant-driven hedge funds as the latest mutants of financial baddies. The real purpose -- here, anyway -- is to expose the susceptibility of less-than-perfect capital structures to this new sort of opportunism. One source depicts "falling angels" as the most vulnerable, if only because their proximity to covenant missteps can generate three-way conflicts among their banks, bondholders and management. Gannett certainly fits the category, having seen its credit rating fall from stellar to speculative over a year. And despite agreeing to credit amendments in October 2008, it still appears to be moving toward a covenant problem.

The most pressing of the credit amendments replaces an equity requirement of at least $3.5 billion with a senior leverage ratio of less than 3.5 times. (Such an amendment was necessary, obviously, considering Gannett's market capitalization has fallen below $1 billion in response to a stock price that's 85% off its 52-week high.) Gannett, in its most recent 10-Q, puts this ratio of senior unsecured debt to Ebitda on a trailing four-quarters basis at 2.92 times. It also asserts the ratio "will remain below 3.5x during 2009." Some dismiss the assertion as wishful thinking, however, citing analysts whose consensus Ebitda forecast for the company comes in at $922 million for all of 2009. This Ebitda forecast would accommodate debt of about $3.2 billion at year's end and still keep Gannett in compliance. Yet, as a maximum threshold, it's already $500 million less than the net debt of $3.7 billion reported at the end of the first quarter.

Meanwhile, back-of-the-envelope estimates for 2009 put Gannett's interest expenses at around $200 million and taxes at around $300 million, while the company itself has budgeted capital expenditures of $148 million. These outflows would reduce to $274 million the amount of consensus Ebitda that could be applied to debt, leaving Gannett $226 million shy of satisfying its year-end leverage test. Small wonder, then, the company elected in February to cut its quarterly dividend to 4 cents per share, from 40 cents. The rabbit-out-of-the-hat maneuver -- awaited by Gannett critics for years -- permits the reallocation of $325 million in annual free cash flow. A reallocation of this size has the potential, theoretically, to keep the company in compliance by $99 million. Granted, it's not much of a cushion, given the newspaper industry's continuing free fall. And the notion that it could easily be undermined by a rounding error elsewhere in the company can't be much comfort to Gannett's banks.

Those banks haven't been comfortable in a while. But the word is they were made really uncomfortable by Gannett's offering to share with "new" noteholders the same guarantee by certain subsidiaries that used to be exclusively theirs. Although the exchange brought only $260 million in "new notes" under the guarantee, that doesn't preclude Gannett from trying to entice additional "new" noteholders with even sweeter terms in future exchange offers. And what if Gannett really does call it quits, as so many CDS buyers seem to expect, after paying the $432 million in notes maturing in June 2011? What does that mean for Gannett's $280 million term loan from banks due the next month?

The banks face a decidedly tougher choice in March 2012 -- provided the proverbial can gets kicked that far down the road -- when they weigh whether to roll over Gannett's revolving credit agreements. The revolvers will carry a $2.75 billion maximum at the end of 2009, having been reduced to $3.1 billion now, from $3.9 billion in October 2008. But $2.75 billion is still a lot to consider, especially since $306 million of Gannett's 6.375% "old" notes come due the month after the revolver is or is not renewed. "Why roll over billions of a secured maturity for a shaky customer when it has another security right behind it?" questions the distressed-debt expert. "The answer is you don't."

Next month, after Gannett releases second-quarter results, its ability to put off a covenant trip will be much more apparent. The release will be followed by an earnings call that opens with prepared statements from CFO Martore and, if he's back from a temporary medical leave announced June 15, CEO Dubow. The Q&A session that traditionally wraps up this call will likely include some of the most pointed questions ever directed at the company, and the executives fielding them can certainly be excused for wishig Neuharth was at their side. But the public face of Gannett hasn't participated in quarterly calls for more than a year -- the annual meeting is his thing -- and it's doubtful he would have much to add if he were there.

Yes, newspaper companies are in such trouble that even Gannett, arguably best of breed, faces challenges few imagined two years ago. Yet the most immediate challenge has little to do with the news business -- just as this story has little to do with the news business -- but features forces so opaque and arcane that Gannett's thinly staffed dailies will be hard-pressed to cover them.

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