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 Federal Deposit Insurance Corp. (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.
They’re back partly because the recently passed federal spending bill reversed a Dodd-Frank rule that said big gambling banks had to separate CDS into units not guaranteed by the FDIC (aka taxpayers).
While I may come back to that, I’m not writing about Congress‘ latest gift to Wall Street today.
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.
For example, RadioShack Corp. (NYSE: RSH) has about $1.4 billion in outstanding debt (bonds and loans), and so the storied retailer is in trouble. Speculators betting on RadioShack defaulting, however, have 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 burnt 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.
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.
Now, with Dodd-Frank being eviscerated, we’re going to see many more of these bets. It’s another way to make money – and Wall Street loves to make money.
I warned about CDS back on September 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.
- Wall Street Insights & Indictments: Wall Street’s Big Boys Bulldoze Through the Spending Bill They Want.
- Wall Street Insights & Indictments: How Goldman and D.C. Hosed AIG – and the Taxpayers.
- Money Morning: Dear Hank: Here’s How to End the Credit Crisis at No Cost to Taxpayers.