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RadioShack Stock Is Caught in a Game … And That Game Changes Monday

All of a sudden, the institutional interest in keeping a clearly unsalvageable RadioShack Corporation (RSH) alive makes sense.

Radioshack stock rsh stockThe hedge funds that seem willing to throw away good money after bad to keep the company afloat during its so-called turnaround effort don’t have a long-term stake in RadioShack stock. They’ve simply placed huge bets that the company would evade default (and bankruptcy would indeed prompt a default) for at least a little while longer.

The problem is, those are limited-time wagers. Once they pay off, the apparent financial support for struggling RSH is apt to vanish without warning.

And so will what small value remains in RadioShack stock.

Credit Default Swaps Rear Their Ugly Head Again

Remember the term “credit default swaps”? For some investors, it’s a proverbial four-letter word, as credit default swaps are what made the subprime mortgage meltdown in 2008 much worse than it needed to be.

A credit default swap (or CDS) is, in simplest terms, a way of hedging against the negative impact of what happens when a debtor stops paying interest on debt.

In 2007 and 2008, many borrowers took on house payments they couldn’t actually afford thanks to the high “subprime” interest rates those loans commanded. And many of them simply stopped paying. Lenders (or more specifically, the owners of those loans) would have been out of luck too, had they not purchased insurance on those loans (credit default swaps) that offset the downside of a default — usually a sharp decrease in the value of the underlying bond.

Had lenders simply used credit default swaps for their intended purpose as a hedge, 2008’s mortgage meltdown might never have become a full-blown crisis. Greed can be blinding, though, and when it was recognized how seemingly easy it was to make good money by speculating with credit default swaps — even without owning any mortgage loans — these type of contracts became Wall Street’s new favorite drug.

It all went sour, of course, as speculators were betting sub-prime borrowers would easily be able to make their house payments. They didn’t, and the bulk of those CDS speculations went belly-up. The economic ripple effect was enormous, as the credit default swap betting pool ended up being many times larger than the size of the actual losses on bad mortgage loans.

Great. So … what does any of this have to do with RadioShack stock?

Already forgetting the lesson learned in 2008 (well, apparently not learned), RadioShack has become the newest and one of the biggest credit default swap guinea pigs in the world. Unlike the 2008 subprime crisis though, owners of the credit default swaps for RSH have enough cash and enough potential profits on the table to keep the company alive long enough to collect a tidy profit on their wager.

Once the bet’s time frame is done and the CDS expires, however, that optimistic interest and financial support may well vanish.

Problem: A big tranche of credit default swap wagers will expire on Saturday, Dec. 20. It remains to be seen whether RSH will continue to find enough financial backing before complete insolvency materializes.

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RadioShack Stock is (Still) in Jeopardy

As of this week, $25 billion worth of credit default swaps were betting that RadioShack would not default on its debt.

Don’t misunderstand that figure. There’s not $25 billion at stake. The actual at-risk capital is somewhere closer to $600 million, down from about $1.1 billion earlier in the year. All the same, the strange ease with which struggling RSH was able to secure a $585 million loan offer from hedge fund Standard General and other hedge funds in October now makes much more sense — if the company can simply keep paying on its debt for a bit longer, CDS bets on RadioShack’s continue solvency could mean a decent profit for Standard and other hedge funds willing to chip in at the time.

Conversely, last week, Salus Capital was insistent that RadioShack had already defaulted on a $250 million loan by violating the terms of the loan agreement. A panel of credit default swap dealers — a group that essentially rules on the gray area inherent with derivative trades like credit default swaps — decided that RadioShack didn’t violate the loan terms, and therefore no triggering event for a CDS payout had occurred.

Though not confirmed, one has to at least wonder if Salus was on the other side of the default bet, assuming RSH would default while Standard General and other hedge funds were betting it wouldn’t.

It should matter to investors, because some of these credit default swap agreements expire this week. With no viable reason to ensure the retailer’s solvency, the company’s needed funding may dry up surprisingly fast. Some of these CDS wagers don’t expire until early next year, though it’s not clear how much of the $600 million wager is set to remain on the betting table that long.

And at that point reality sets in: RadioShack stock hasn’t completely imploded yet not because RSH has a shot at evading bankruptcy, but because it has been in the best interest of some hedge funds to keep the company alive and paying its bills.

Indeed, one has to wonder if the loan offers it received in September and October were deliberately contentious to drag out the process, holding the carrot of hope out close enough to serve as a light at the end of the tunnel, but far enough away to make sure RSH kept servicing its debt to ensure it would be eligible for new loan offers.

Is this sort of thing illegal? No. Is it immoral? That’s a matter of perspective.

There’s no doubt it’s effective, however, even if it offers false hope to existing owners of RadioShack stock.

Bottom Line for RSH

It remains to be seen whether on Monday the bottom will drop out of the support RadioShack has thus far been getting from the hedge fund and institutional trading industry, but nothing can be ruled out.

Considering RadioShack has posted generally widening losses for eleven quarters in a row though — with no real turnaround in sight — it’s difficult to imagine the trading syndicates and funds that have bet against a default via credit default swaps truly think RSH is a viable stock with any real future upside. The company has lost more than $100 million in its past two quarters, on sales of less than $700 million each quarter. That’s miserable, and largely insurmountable, by retail standards.

And as an indication of just how quickly the tide can turn on RadioShack stock, it was only in June of this year the overall credit default swap picture for RSH said hedge funds and institutions collectively figured there was an 86% chance of default by June of 2015. Now the speculation industry is fighting tooth and nail to stave off default.

The tide could turn just as quickly again, though, and sooner than many investors realize.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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