How the Masters of the Financial Universe Use Derivatives for Fun and Profit

[Editor's Note: This inside look at the shady world of derivatives was first published Dec. 9 in Shah Gilani's Wall Street Insights & Indictments. To get all of Gilani's insights as soon as they are released, click here.]

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Jon Stewart just did a very funny piece on "The Daily Show" about a new derivatives dust-up that Bloomberg News broke.

Earlier this year, a big Wall Street firm bought a credit default swap on debt that a private company owed to a third party. So the firm was set up to make money if that company missed any payments.

Then the firm offered the company a multi-million-dollar loan... with the condition that they would miss a payment on the other loan. They did. And the Wall Street firm walked away with a $15 million insurance payment.

Sound less than kosher? Oh, don't worry. It's perfectly legal.

"The Daily Show" team pointed out that this behavior isn't illegal but maybe should be, and that the media didn't cover it at all and maybe should have.

But there's something they missed, and it's even more frightening.

Here are the details...

There's More to the Blackstone-Codere Deal

Last year Spanish gaming company Codere SA was in deep doodoo. They still are. They had a bunch of outstanding bonds (more than 1 billion euros worth) that they were likely going to default on.

So, in comes GSO Capital Partners LP, a credit investing unit of the world's biggest private equity firm, Blackstone Group LP (NYSE: BX). GSO buys up a package of Codere's outstanding debt and CDS (credit default swaps) on the same debt.

Credit default swaps are derivatives. They are a type of insurance. Say you invested in Codere's bonds and you're afraid they might default and you won't get paid your interest or principal. You can buy CDS from, most likely, hedge funds or banks, and pay them premium monthly payments, just like you would on any insurance policy. If Codere defaults, you get paid and are made whole.

Well, GSO bought Codere's debt and CDS insurance on that debt. Makes sense, right?

GSO also bought out a syndicated revolving line of credit for up to 100 million euros that several banks had set up for Codere. GSO then went to Codere and said, "Hey we now control whether you're going to get any money out of this loan facility. And we'll loan you what you need to make payments on your outstanding debt, so you don't default."

But that wasn't the whole deal.

They also said to Codere, "We want you to make your next payment two days after it's due, so you technically default. Then we'll loan you the money to make your interest payment."

And that's what happened. Codere had a deal to get the money it needed to pay the interest due on its debt. But GSO wanted it to technically default by not making the next payment on time. That's because GSO wanted to collect on the insurance it bought on Codere defaulting.

Nice game, huh?

Again, Jon Stewart and his crew at Comedy Central covered this story last week. (Google "Daily Show Blackstone Codere" to watch it.)

But the situation is a little more complicated than Stewart makes it out to be.

Here's the rest of it.

Yes, GSO made Codere default so it could get paid on its default insurance (if you're a hedge fund or bank that sold them the insurance, trust me, you're pissed off). There were plenty of other investors who owned debt that were going to get paid on their CDS insurance too.

The game wasn't just to collect the insurance...

The $15 million insurance payment GSO got was nice, and it was nice for other investors who got paid too. But the cleverness of the deal was that GSO forced the company's creditors to the debt negotiating table to restructure their debt once they defaulted. Without the default, the insurance wouldn't have gotten paid, and there was a chance creditors would have renegotiated to keep the company going in hopes it eventually would pay off its debts.

GSO bought the debt to be in a better position holding it after it got paid on the insurance and after it forced a debt renegotiation on the other creditors.

That's the power of derivatives in the hands of Masters of the Universe.

Were others burned on the deal? Sure, but who cares if you've got the smarts, muscle, and capital to rig the game to your benefit?

Derivatives are weapons of mass destruction. You may not think these little derivative dust-ups affect you, and maybe they don't - at least not directly. But there are some players in the business who don't know what they don't know, and that's scary for all of us. It's the players who didn't know how the backdoor game could be played who really suffered. That will be a lesson they won't forget.

Speaking of forgetting... Things are all quiet on the derivatives front after the credit crisis that was grossly aided and abetted by derivative weapons of mass destruction, right?

Wrong.

One of the dangers of derivatives is that they're "bilateral contracts," meaning they're private, two-way trades that aren't exchange traded and therefore are not transparent.

Dodd-Frank sought to remedy that by making certain U.S. traders in certain derivatives trade them on exchanges called swap execution facilities (SEF). But there's a problem with that solution.

You see, U.S. regulators can't make other traders in other parts of the world follow U.S. rules if they don't do those trades in the United States or with U.S. entities as counterparties.

Of course that's not a problem for U.S. banks and derivatives traders. They're just setting up foreign subsidiaries (if they don't already have them, which most do) in London and Hong Kong and elsewhere to do business outside the United States so as to avoid doing their business in the open on SEFs.

You can see where this is going, can't you? Just like with the CDS trade deal above, which isn't illegal, U.S. companies were given a carve-out to set up foreign entities to do derivatives trades away from the very same swap execution facilities they were supposed to do their trades on because some or any transparency is better than none.

It's getting bad. Now, not only are more derivatives trades (by U.S. entities) being done away from prying eyes in places where regulations are far more lax than in the United States, but by spreading their trades around, traders are splitting markets. That "fragmentation" is going to undermine liquidity and "netting" that's an absolute must when stresses in the derivatives markets cause the whole dance floor to shimmy and shake.

So what's the moral of the story?

The derivatives dance is a dangerous waltz. Pick your dance partners well, and when enough punch is spilled on the dance floor, realize that that ain't a new dance derivatives traders are doing, it's probably the electric slide... as in slide off a cliff.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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