A hedge fund that filed a lawsuit seeking to have $14.3 billion of Illinois bonds invalidated in court stands to reap enormous profit if the case succeeds and the state defaults on the debt, Nuveen Asset Management and AllianceBernstein alleged in court filings.
New York City-based Warlander Asset Management purchased credit default swaps that will pay off if the lawsuit causes a default, according to Nuveen and AllianceBernstein, which own about $2 billion of Illinois bonds, including those challenged in the case. Jonathan Gasthalter, a Warlander spokesman, didn't immediately respond to a request for comment.
"Permitting activist investors to litigate against the validity of widely held municipal bonds based on their credit default swap bets could introduce a significant destabilizing force into the municipal markets and harm investors and government entities alike," Nuveen and AllianceBernstein said in a brief filed Aug. 9 in Illinois Circuit Court.
Warlander and the chief executive officer of the Illinois Policy Institute, a conservative think tank, sued Illinois Gov. J.B. Pritzker, saying the state's 2003 pension bonds and 2017 debt sold to pay bills were deficit financings prohibited by the state constitution. Both issues were done before Pritzker took office this year.
Warlander, which owns $25 million of Illinois general-obligation bonds that would be more secure if the firm succeeded in having the other securities invalidated, disclosed in a footnote in its complaint that it also had a "separate financial interest" in the litigation. That separate financial interest involves credit default swaps "well in excess of its nominal $25 million bond position," Nuveen and AllianceBernstein said, without providing specific evidence.
A hearing Thursday in the circuit court of Sangamon County may determine if the lawsuit, filed July 1, has standing or should be thrown out. The court should require Warlander to disclose the nature, terms and extent of its separate financial interest "so that the court can determine whether the petition is filed not to vindicate the interests of Illinois taxpayers but to allow an out-of-state hedge fund to create a default and profit from the swaps," Nuveen and AllianceBernstein said.
If Warlander's true financial interest lies in creating a default so it can profit, then the lawsuit was filed with a "malicious or ulterior purpose" and the court should reject it, Nuveen and AllianceBernstein said.
A credit default swap contract is similar to insurance on a bond, but the purchaser doesn't need to own any of the underlying debt to buy one. The swap purchaser can buy the bonds after they default and then tender them to the swap seller to get full payment on the contract.
Credit default swaps on Illinois general-obligation bonds exceeded $300 million at the end of June, according to International Swaps and Derivatives Association data.
The lawsuit has already impaired Illinois bond prices and made it difficult for the state to issue new securities, the funds said.
The spread on Illinois' 2003 and 2017 general obligation bonds rose by 36%, to 182 basis points from 134 basis points, and the trading price dropped relative to the broad market after the Warlander suit was filed, according to Nuveen and AllianceBernstein.
Holders of the bonds had a paper loss of $574 million, the funds said. Illinois postponed until the fall a general-obligation bond sale to pay more bills.
Warlander's suit is based on an incorrect reading of the Illinois Constitution, Nuveen and AllianceBernstein said. Article 9, Section 9 of the constitution says the state may issue long-term debt only to finance "specific purposes" if approved by three-fifths of the legislature or by popular referendum.
A "specific purpose" refers to a description, not a limitation on the power to incur debt, the funds said. The three-fifths vote requirements acts as a limitation on the ability to borrow.