Thursday, October 24, 2013

Credit default swap jujitsu

Credit default swaps (CDS) are just insurance on a loan. So when you buy a CDS, you're betting against a loan. And it doesn't have to be a loan you made. You can bet against a loan someone else made too. It'd be as if you could take out car insurance on someone you think is a bad driver. So if the loan defaults, you stand to make money. And if there's no default, you just wind up coughing up premium after premium, paying for car insurance on your good driver who never gets in an accident. ...

But even with these financial shock absorbers, there are still lots of clever-and-probably-legal-but-ethically-dubious ways to game CDS. Here are the two most devious.

1. Buy CDS on a bond, and then bribe the borrower to temporarily default. This is like taking out insurance on your neighbor's car and bribing him to get in an accident. You get the insurance, and then you kick some money back to him to upgrade his car.

Sound far-fetched? It's not. It's essentially what a unit of the Blackstone Group did with the Spanish gaming operator, Codere SA. First, Blackstone bought insurance on Codere’s bonds, so it stood to make a nice bit of money if Codere missed an interest payment. But how do you make a company miss an interest payment? Well, Blackstone took over one of Codere's revolving loans, as a hostage, and told the gaming company: "We'll force you to pay back this entire revolving loan unless you kindly miss the next interest payment on your bonds." It was a clever ransom. And guess what? The clever ransom worked. The interest payment came late. Blackstone made $15.6 million from its CDS. And as for Codere, they turned out fine, too. Blackstone agreed to restructure its bonds, and reward the company for good behavior with another $48 million loan.

2. Sell so many CDS on a bond that you can pay to keep it from defaulting. This is like selling insurance to as many people as possible on a car that was obviously falling apart — and then paying to fix it before it could get in an accident. ...

Now, imagine some crappy bonds. ... What if Wall Street could find someone crazy enough to insure all these bonds guaranteed to default? Well, that insurance would be expensive, and everybody would be happy to buy it. In fact, it'd be so expensive, and there'd be so many people happy to buy it that the fool who sold it all would have quite a bit of money upfront — enough to buy up all the bonds it had insured. And to buy them up at above-market prices, too!

See, there are certain types of bonds you can pay off before they come due if you pay an above-market price. Let's say our crappy bonds are these type of callable bonds. In that case, our fool who insured these crappy bonds has just made it so they will never default. Not so foolish after all. It's a risk-free profit, and it's what Texas-based Amherst Holdings did back in 2009. It sold about $130 million of insurance on $29 million of subprime bonds to banks like JP Morgan, Bank of America, and Royal Bank of Scotland. Then it paid above-market prices on those $29 million of bonds to prevent them from defaulting.
--Matthew O'Brien, Atlantic, on gaming the swap