Unlike most of my posts, which are more boring than Sunday afternoon tea at Grandma’s house, we’re actually going to have fun with this one! See, look how fun this is! I’m using exclamation points, so you know it’s all fun and games and probably rainbows! !!! ! You should probably settle down a little before we get started. Here’s a paper bag to hyperventilate into.
First off, let’s look at what credit default swaps are. You probably remember those from the financial crisis of 2008-09, assuming you weren’t weeping every time you looked at your stocks. All they are is a contract benefiting one party when a second party defaults on their debt. A third party, usually an insurance company, will insure company A’s debt, paying out company B if company A ever misses a debt payment.
In theory, credit default swaps are simple. If I lent a bunch of money to a company, it might make sense to sacrifice some of that return and buy insurance on the debt. That’s essentially what credit default swaps are, an insurance policy. It’s kinda like the bank taking out a fire insurance policy on the house they lent money against. It’s a prudent risk management move.
When it gets more complicated is when an outside party uses credit default swaps to make a bet on debt he doesn’t even own. That investor doesn’t buy the credit default swap because they want insurance, they want an easy way to bet on the future of a certain company. Before the mortgage crisis of 2008, this is exactly what a few investors did, using credit default swaps to bet against the crappiest mortgages.
In exchange for only a few million every 6 months, these investors were taking on positions worth billions. If I remember correctly from Michael Lewis’s book on this, (The Big Short, which is highly recommended) the premiums on these credit default swaps were only 10 or 20 basis points per year. Meaning, an investor could bet against $1M worth of mortgages for only $10-20k. It doesn’t take a genius to figure out how this can end up very bad, especially considering AIG was taking these premiums as fast as they could.
Okay, you all are up to speed on what a credit default swap is. Let’s get to the fun part, how one company used one to make a lot of money and make a pretty clever trade.
Enter Blackstone, one of the largest money managers in the world.
Blackstone was cruising along, looking for somewhere to put their cash to work, when they discovered a Spanish company called Codere. Codere was struggling, and needed some money. Blackstone saw the opportunity, and agreed to lend Codere $100M, on one condition.
That condition was that Codere would pay interest to the existing bondholders two days late. It wasn’t much to ask, and Codere knew Blackstone would give them enough money that they’d be good, so they went ahead and did it.
It seems like an odd request on the surface. Why would Blackstone make that a condition of getting their money? Because Blackstone had worked behind the scenes and taken out a credit default swap on the very debt it was asking Codere to technically default on. Blackstone made something like 15M Euros on the deal.
Go here to Bloomberg to read the whole story. Jon Stewart also made fun of it at some point too, but I’m too lazy to find that link.
It brings up an interesting moral dilemma, and if someone had the attitude that Wall Street exists just to screw people, this story would probably harden their resolve. I look at it the other way – if you’re sophisticated enough to be dabbling in credit default swaps to begin with, then you should have been smart enough to see something like this coming. They’re the financial equivalent of using big tractors near power lines.
But the biggest lesson is never underestimate ingenuity when there’s money to be made.