Editor's Note: Credit default swaps, the risky derivatives that starred in the last financial crisis, never truly disappeared - and now they've made a comeback. The latest system-gaming scheme, which Shah first exposed in 2014, may be even more maniacal than the last...
The madness of the manipulation machinery on Wall Street knows no bounds.
Remember credit default swaps (CDS)? They're the risky financial derivatives traded among FDIC-insured banks that, during the 2007-08 financial crisis, took down Lehman Bros. and almost bankrupted giant insurer AIG Inc. (NYSE: AIG).
Well, they never went away. And now they're making a comeback, and Wall Street is using them in ever more maniacal ways.
Today, I'm going to show you how Wall Street manipulators are using CDS and a false front of "activism" to make huge profits from troubled companies - and why that's becoming routine.
Good Idea Gone Bad
This is about outright, legitimized (as in it's not only legal - it's business as usual) manipulation.
Think of CDS as a kind of insurance. Companies issue debt, and investors buy their obligations to collect interest and expect their principal to get paid back at maturity.
But sometimes debtors get into trouble. CDS sellers offer the holders of debt insurance against the debtor defaulting.
That's not a bad idea. In fact, it's a good product.
But, Wall Street being Wall Street, that good idea became a great way to gamble. That's because there's no limit on how many "insurance policies" can be written on any company's debts.
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For example, RadioShack had about $1.4 billion in outstanding debt in 2014, and so the storied retailer was in trouble. Speculators betting on RadioShack defaulting, however, had bets that add up to about $23.5 billion.
That's like everyone in your neighborhood taking out fire insurance on your house. These gamblers would be hoping your house burned down so they could collect.
Sooner or later, someone might toss in a match to light the pile of potentially profitable bets.
Of course, that's happening on Wall Street.
The RadioShack story is complicated. To keep it simple, today I'm going to let you know about a less known but less complex example of CDS manipulation...[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
When Debt Is a Bad Bet
In 2013, the Spanish gambling company Codere SA (BME: CDR) was in financial trouble.
Moreover, its managers didn't know that GSO Partners, the debt-trading arm of Blackstone Group LP (NYSE: BX), had amassed a pile of CDS, betting that the company would default. Then Codere received an offer of help in the form of a desperately needed loan from another Blackstone unit.
That's weird, right?
Not if you're the Blackstone Group.
The loan came with a provision. For Codere to get the loan, it first had to default on its outstanding debt.
That's right: Codere got a loan from a Blackstone unit to avoid default. However, to get the loan, Codere first had to agree to delay interest payments on its other debts. Not paying that interest constituted a default. That made the CDS bets winners.
In other words, "activist" investors are now targeting companies and playing them like pawns.
Another such deal saw a trio of hedge funds buy CDS protection on a company's debts and, at the same time, buy enough shares so they could vote down a plan the company had to merge with a stronger company.
How's that for manipulation?
The company outsmarted the hedge funds by setting up a poison pill so it could sell itself.
I warned about CDS back on Sept. 25, 2008, before the credit crisis reached its zenith. CDS were a big part of what caused the credit crisis. Of the 15 points in my "How to End the Credit Crisis at No Cost to Taxpayers," No. 4 was:
Only allow issuance of credit default swaps up to the actual outstanding dollar value of corporate debts and loans outstanding. This will ensure legitimate hedging and eliminate undue pressure on outstanding debt issuers.
It's that simple.
Then again, it's just as simple for Wall Street and its moneymaking madness to manipulate Congress, the White House, and the financial regulators.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.