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

Shah Gilani

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…

Shah Gilani

About the Author

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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.

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