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

18 | By 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…

Last year Spanish gaming company Codere SA was in deep doodoo. They still are. They had a bunch of outstanding bonds (over one 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 money 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 burnt 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?


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 U.S. 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 U.S. 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 form 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 U.S., 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.


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

  1. Malcolm Jensen says:

    What GSO Capital Partners did, as you describe it, looks a lot like insurance fraud to me. How is it not?

  2. Alabama Dave says:

    Yes it is a very hidden game. But if you follow the money trail back far enough. It leads to the Fed and the bankers that hide behind the curtain.

    It is all fake money because when the American people really find out the truth, which they are starting to add up the pieces. The game will come to an abrupt end.

  3. M Tanner says:

    This may be a stupid question, but why don’t the sellers of the CD Swaps simply have some legal boilerplate in their sales contract which precludes a payment where the purchaser(s) (or their agents/cronies/collaborators) are instrumental in triggering the default?
    i.e., “caveat venditor”

  4. kevin says:

    Derivatives! derivatives!
    What is it with derivatives?
    Who derives, and who survives/
    And at what cost are many lives so fractionalized?
    Pennies on the dollar for pieces of a company pie
    Which crumbles, but is insured by those who live or die,
    by derivatizing and improvising

    • Victor Allis says:

      well said, your like a poet with the thunder of the skies blasting through to a full moon on to earth bound destiny of good and evil. Keep up the great writing.

  5. Veronica says:

    thank you for this great explanation of the derivatives game – I am completely convinced that we need Dodd Frank+++} at this point – I am wondering what we can do to get this under control – how do these ‘barons’ of money sleep at night ? By comparison, the little guy is a complete paragon of virtue, surely there must be some pay-back for their sins – where is the justice ???
    I am so glad I do not find myself (or anyone I know) stooping to this level of ‘poop’.

  6. Terry says:

    What legitimate purpose do derivatives have? They sound like a paper roulette wheel and just a method for gambling? A clearing house in LV might be in order? The SEFs no doubt need more govt employees meaning someone in the know, of the right person, gets to be director, and becomes beholden. If derivatives were eliminated, then hundreds or thousands or how ever many are required to regulate them would not be needed. How many new govt employees are needed to do us in, oops manage ACA?

    We have financial communism. Govt does not own much, just controls everything. America’s royalty strikes again. How much is spent on admin of SS and Med-icare and -caid? And no student left behind? But the taxpayers are sure left out!

    This is same as foundations and trusts. Assets don’t pass to next generation since assets are “inheritally” taxed. Control is not taxed, which is what is transferred. Also govt bonds, etc. are where the super rich “invest” their money. Too dangerous to invest in the free markets. They might lose their wealth and be like the rest of us. Plus it keeps the estate intact.

    Remember the old pension plans, where someone in the company had to manage them, like state, city (Detroit) or union pensions. Managing them is the illusion of knowing what you are doing. Only the fed can print money making their pensions gold plated. We do have a number of structural problems in govt’s financial operations. But all this stuff was legislated years ago, maybe 100 years ago by the capitalists. AKA bourgeoisie. I don’t recall reading about any Christ like robber baron or union boss who gave up his profit for the good of the proletariat? I do remember reading about Scrooge.

  7. Terry says:

    And investing in govt bonds/paper helps the govt meet it’s obligations so is very good for the country. Why O has even said the govt must not default. Yes, the power of thinking and it is nice he can cherry pick what to scrap when sequestering. Like tours of the WH, those annoying pesky tours.

    It seems that govt is a financial and political cancer on society. How do you control it? By restricting it’s life blood. Money.

  8. Bernierd B. says:

    If they take them to court, back room agreements will take place, they will pay a fine out of the profits they made with this “honest stealing”, and will not have to admit any wrongdoings, as usual. I wonder if, no, I am sure they run their lobbyists, the great cancer in our political system, in with wads of cash to put on a show but not convict anyone. If we could only follow the money, it always takes us to the perpetrators.

    So what do we have?
    Elected lawbreakers?
    Elected mis-representatives?
    Elected mis-fits?
    All of the above?

  9. Bernierd B. says:

    Jon Stewart of the Comedy Channels Daily show, 7:30PM EST, Monday through Friday, tells us more of what is really going on than the real, if you can call it real, newscasters. Not every show does this, as some are nonsense, but now and then, does he ever “out” the government, it’s financial cronies and the newscasters that are supposed to maintain our free press to expose government wrong doings. Great work Jon.

  10. Edouard d'Orange says:

    Just when you thought it was all safe now, the banks were reined in, the players had been burned and now are shy, you find out that the derivatives nonsense that contributed to the last crisis is growing bigger and dangerous. No one is reporting about: 1) the CDS swap scam game, 2) the foreign derivatives trades and traders and how much business is being done in these foreign deals, in other words, no transparency. Looks like we’re on the same road as we were on in 2008. You got to give these bankers some credit for their sneaky, nimble actions. But you have to condemn them for what they are doing and expose them.

  11. tom says:

    This sounds like an episode right out of the Sopranos. In fact, I wish it was because someone would have been wasted by this time and maybe this entire game would stop.
    The big question is if this is a house of cards, why do we all have to get screwed by something we had nothing to do with it. This is totally immoral.

  12. Tom Hegarty says:

    How the hell would the average citizen find their way through a financial maze like that?

    Where to look?

    It seems almost like some kind of shaminism, reading the bones or sniffing the wind for clues.

    This has to be stopped, it’s rotten through and through, dishonest doesn’t even get near it.

    (Do you think there might be a Hell, just wondering………?)

  13. r2d2 says:

    As of last spring during 2012 JPMorgan had 75 trillion dollars in derivatives, Citibank had 52 trillion dollars worth, Bank of America had 50 trillion dollars worth and Goldman Sachs had 44 trillion dollars worth of derivatives. World GDP was estimated to be 60 trillion dollars.

  14. Brad Morgan says:

    Good, old fashioned loans, treasury notes and other “normal” types of investments just aren’t exotic enough or offering enough return for the financial institutions. So, they will come up with every conceivable angle possible to make more money, unfortunately taking more risk too, constructing such things as derivatives. Derivatives are actually nothing new, but the incredible volume of them that exists today along with their less regulated nature does cause concern. Most derivatives are interest rate swaps. There are literally trillions of dollars worth of these out there. What happens if we get the Fed uncontrolled, rising interest rate environment many see as inevitable? Talk about potential for another derivatives blood-bath. Who gets bailed out of that one? Will there be any money to bail them out with? The problem with this much paper backed by essentially nothing, is that when some economic trigger event brings all the holders calling for their pay day in synchronicity, there is nothing there to pay them with.

  15. Dee Elwood says:

    Careful, You will deprive a sizable segment of the business community of a practice of legal
    theft which they have benefited from over these past 75 years.

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