Published October 25, 2013

How to Make $15.6 Million, Risk-Free

Dear Reader,

Dan Steinhart here, filling in for David Galland.

What if I told you about a foolproof investment that's a guaranteed winner? One that will pay you $15.6 million, with exactly zero risk of loss?

It's true. And you don't even need to give Prince Abogaye your bank account information.

You just need to be a Wall Streeter. A questionable moral compass helps, too. Here's how.

Earlier this year, the Blackstone Group, the world's largest private equity firm, loaned $100 million to a small, struggling European company called Codere. Blackstone included an odd stipulation in the loan agreement: that Codere must not pay the interest due on a separate, unrelated loan. If Codere didn't comply, its $100 million loan from Blackstone would become due immediately.

Codere, struggling to survive amidst six running quarters of losses, needed Blackstone's cash. So when the August 15 interest payment came due, it obeyed Blackstone and did not pay. Nor did it pay within the 30-day grace period, even though it had the money to.

Instead, Codere purposefully triggered a default by waiting to make the interest payment until the grace period was over.

By now you should be asking at least two questions. Why on earth would Blackstone coax its debtor into defaulting? And more importantly, how did it make money doing so?

Follow the Money

Here's the missing puzzle piece: earlier this year, Blackstone purchased Credit Default Swaps (CDSs) on Codere's debt.

A CDS, if you're not familiar, is basically an insurance contract. If you own a McDonald's corporate bond and you're worried you might not get your money back, you can pay a counterparty to assume that risk. Then, if McDonald's defaults, the counterparty must pay you for your losses.

Or, if you're really adventurous, you can buy CDSs without owning the underlying bond, which is essentially a speculation that McDonald's will default on that bond.

Unless, of course, you have influence over the fast-food giant's management. Then it's not a speculation at all. It's a can't-lose trade.

That's what Blackstone did. It took out an insurance policy on Codere, persuaded it to default, then collected $15.6 million in payouts. There was never a chance Blackstone would lose money on this arrangement. It was literally a risk-free trade.

Now, I'm no lawyer, but that sure sounds like fraud to me. If I took out an insurance policy on my neighbor's house, then convinced him to burn it down, the police would want to have a word with me.

But apparently, this is neither fraudulent nor illegal, because both Codere and Blackstone agreed on the terms. Curiously, the party that most certainly would not have agreed to the terms—the underwriter of the CDS insurance policy—isn't mentioned in any of the reports on this young story. Blackstone's gambit cost that unnamed company at least $15.6 million, and probably a lot more, since other parties also held CDSs on Codere's debt.

I would have liked to be a fly on the wall when Blackstone lawyers had their eureka moment. I picture a team of suited professionals proudly explaining this loophole to Blackstone's investment officer and enjoying his reaction:

"Wait a minute… you're saying we can screw someone out of $15.6 million, with zero risk to us, and it's completely legal? Where do I sign?"

Again, I can't help but draw parallels to the real world. What Blackstone did is tantamount to someone purposely totaling their car to collect on insurance. Obviously there are clauses in GEICO contracts that define such actions as fraud and protect the insurer from having to pay out on bogus claims. But apparently, CDSs lack that clause. Or at least this particular CDS did.

Investment implications? If you're going to invest, make sure you truly understand what you're doing.

I don't imagine many readers of this missive trade CDSs. But the lesson applies equally to retail investors. Just last week, on a company-wide call about the state of the markets, Casey Research Chief Economist Bud Conrad shared the following chart. It looks like a heat map, but it's actually an incredibly granular look at action in the gold market over a ten-minute period on October 11, when an anonymous seller dumped a massive sell order on the market.

Usually, when a seller wants to unload a large position, it sells a little bit at a time, so as not to depress the price. Entering the entire order as one big trade is akin to flushing money down the toilet. Yet that's exactly what this eager seller did, dropping 5,000 gold contracts all at once, knocking the price down $20 in a matter of seconds.

This wouldn't matter to you, unless of course you had set a stop-loss order on gold anywhere above $1,264. In which case you sold your gold to someone at an awful price.

I'm not qualified to weigh in on the "is gold manipulated" debate, other than to say that this piece of evidence points strongly to the affirmative. If the seller's plan was to knock the price of gold down so it could buy it back at a lower price, it appears to have worked quite well. As I write, the price of gold is $1,348/oz. Meaning anyone who was stopped out at around $1,270 missed out on a 6%+ gain in the past two weeks. And what's worse, there's a good chance they donated those gains to someone who had a better grasp on the inner workings of the gold market than they did.

I'll end the conversation on gold here because Bud Conrad, who most certainly is qualified to weigh in on the gold debate, is hard at work assembling data for a comprehensive analysis of those inner workings of the gold market. In the upcoming edition of The Casey Report, he'll quantify just how much influence the biggest banks hold over the price of gold. If you're at all familiar with Bud's work, you know he'll leave no stone unturned and no data unanalyzed in his quest for the truth.

If you'd like to get your hands on Bud's analysis hot off the press on November 14, click here to sign up for a risk-free trial to The Casey Report. It comes with a 90-day, no-questions-asked money-back guarantee, so you literally have nothing to lose.

I'll now pass the reins over to Robert Ross, my friend and a senior analyst for Mauldin Economics, to explain China's unique and cautious approach to liberalizing its economy.


Capitalism Finds a Way: China’s New Special Economic Zone

Robert Ross, Senior Analyst, Mauldin Economics

Those living in developed countries take many benefits for granted. Whether it's clean water, a stable electrical grid, or grocery stores chock full of anything your palate desires, most people in developed countries are pretty well off. Especially compared to the average person in an emerging-market economy.  

But one facet that many investors take for granted is that in a developed, capitalist economy, most  businesses play by the same rules. That's not the case in the People's Republic of China, where the government allows certain districts to play by their own set of guidelines, in the name of economic development.

Known as "special economic zones" or "free trade zones," these areas of the country have certain perks, such as market interest rates and lower export taxes.

Though the idea may sound strange to outsiders, these zones employ free-market principles to help liberalize certain sectors of the economy. The newest such zone, which opened in Shanghai's Pudong province in September, aims to help modernize the country's service industry, particularly the financial sector.

China has used this approach to economic development since the 1980s, when the country first established special economic zones in certain areas of Guangdong Province, Fujian Province, and Shenzhen. These original zones were geared towards modernizing the country's manufacturing sector, particularly the export of processed goods, by permitting the investment of foreign capital.

Now that the country's manufacturing sector has become a dominant global force, the Chinese government has decided to refocus its efforts on opening up its inefficient, costly services sector—particularly the financial industry. By granting the newest zone perks unavailable to the rest of China—such as letting the market (rather than regulators) set interest rates, allowing firms to convert foreign currencies to yuan, and letting businesses freely move money overseas—the Chinese government seems ready to revamp its financial sector through a healthy injection of free-market principles.

Big Economy, Small Changes

Newly appointed Premier Li Keqiang has touted the ambitious project, which began on September 29, as a symbol of China's commitment to economic change. He's following in the footsteps of Deng Xiaoping, who nudged China towards a market economy using special economic zones starting in the 1980s.

After the death of Mao Zedong, Deng set up the first special economic zone in Shenzhen, essentially walling off the city north of Hong Kong from the rest of the country and allowing foreign manufacturing firms to capitalize on low-cost Chinese labor. It was a monumental success and is often cited as a major factor that turned China into one of the world's largest trading powers.

Although this approach to economic liberalization may seem odd to Westerners, it fits with China's economic narrative, which historically avoids big, bold changes.

It minimizes risks by letting experienced local officials experiment with reforms inside a tightly sealed zone. Policies that don't work can be contained within the area. On the flip side, reforms that do work can be rolled out to the rest of Mainland China.

But since the Chinese government has been intentionally vague on certain rules and regulations, an air of uncertainty hangs over Pudong's potential success.

For instance, the Politburo hasn't addressed how it will keep ordinary Chinese citizens living outside Pudong from gaining access to the attractive interest rates offered by zone-specific banks.

Also, since firms in the zone can convert large amounts of yuan into dollars for use abroad, there is bound to be pressure from outside the zone for similar privileges.

This isn't the first time such issues have come to the forefront. When Chinese regulators turned a blind eye to banks offering "wealth-management products" that paid a higher rate of return than bank deposits, cash that was meant to stay contained in a special economic zone ended up bloating the shadow-banking sector. That hot money eventually made its way into large real estate and infrastructure projects, contributing to China's numerous "ghost cities."

It also made the country more vulnerable to financial shocks, as many of the banks making these risky loans are leveraged to the hilt.

Give Me Golf Courses or Give Me Death!

Though the government is relaxing restrictions, there are signs that the Politburo isn't very keen on ceding all control.

As a part of the deal with Pudong, the Chinese government included a "negative list" of sectors in which foreigners cannot invest. The list cites several vices like guns, drugs, and pornography, which shouldn't be an issue. But it contains over 1,000 banned items, including an odd assortment of activities like news portals, golf courses, and "traditional Chinese tea processing techniques."

Importantly, access to an uncensored Internet—which many touted as a surefire bet—was also left off the table.

"This is a place-holder for real reform," said Derek Scissors, a resident scholar at the American Enterprise Institute. "It guarantees nothing, with at least a chance that something useful is going to come out of it."

Avoiding the Middle-Income Trap

The Chinese government may not have a choice but to do everything in its power to make sure the zone succeeds. Soaring wages and an ageing workforce have aroused fears that the country could fall into what's known as the "middle income trap," a phenomenon characterized by plateauing growth after a country reaches middle-income levels.

To avoid the "trap," an economy must transition from cheap labor-driven growth to growth based on high productivity and innovation. Since the establishment of this new economic zone aims to improve the financial sector, and thus provide smaller Chinese with access to bank financing, it could be a crucial step towards a stable growth model.

But in order to attract major investors, China will need stable regulation, and the government will have to step outside of its comfort zone and let the reforms that work trickle out into the broader economy. That's the only way to foster innovation throughout all of China.

The Chinese government has demonstrated an inability to loosen its grip on the economy in the past. We'll see if it can relinquish control and allow the economy to flourish in the near future.

Robert Ross is a senior analyst at Mauldin Economics. A native of Cleveland, OH, he graduated top of his class from Loyola University New Orleans College of Business with a degree in economics. He currently works on numerous Mauldin publications, including Bull's Eye Investor, Yield Shark, and Transformational Technologies.

Dan again. I have one more article for you today. Did you know that 30 of what were the 50 largest banks in the US in 1980 are now part of Bank of America, Wells Fargo, and JPMorgan Chase?

These behemoths loom over the financial industry, more interconnected than ever. Doug French has more on the astounding consolidation of the US banking system, a phenomenon that all but ensures that when the next crisis comes, these "Way Too Big to Fail" banks will once again have the leverage to hold the US hostage for bailouts, subsidies, and other goodies.

Bigger Banks, Bigger Problems

Doug French, Contributing Editor

Warren Buffett says banks are in better shape than at any time he can remember. US banks have "built up capital, loan losses are down, portfolios are in good shape," the legendary investor claims. "The problem is they have more money around than they'd like."

That's one man's opinion from the outside looking in. But maybe things aren't so rosy. Richard Parsons was a banker with Bank of America and is the author of Broke: America's Banking System. The ex-banker has his doubts.

In a piece for the Wall Street Journal, Parson writes about the comments of FDIC head man Martin Gruenberg who said recently, "Prior to the recent crisis, the major national authorities here and abroad did not envision that these large, systemically important financial institutions (SIFIs) could fail, and thus little thought was devoted to their resolution."

Parsons takes Gruenberg to task for his lack of historical perspective. Indeed, during every rash of bank failures, big banks go down along with the small ones. As economist Murray Rothbard pointed out years ago, there is no other line of business where so many firms fail at the first sign of trouble.

In our fractionalized banking system, one person's deposits are loaned out to another, giving two people title to the same asset simultaneously. This is the fundamental reason that the banking system repeatedly fails in mass.

In an attempt to stave off repeated crises, the banking industry has enlisted plenty of help from the government. The Federal Reserve was created one hundred years ago to stand ready as the lender of last resort. The Federal Deposit Insurance Corporation, created by FDR, provides deposit insurance to quash any bank run.

Still, a run on only 8% of deposits put Washington Mutual, a huge mortgage lender, on the ropes.

The banking system melts down every couple of decades. Parsons points out that six of the top 50 banks failed in the banking crisis of the late '80s and early '90s. While many were allowed to fail, Parsons  quotes former FDIC Chairman Irvine Sprague who identified Continental Bank as "too big to fail," and wrote "scores of large and small institutions—perhaps hundreds—would have been in serious jeopardy if Continental could not have met its commitments."

Creating Monsters

Bank of America stepped in to aid regulators by acquiring two large failed Texas banks in 1988 and continued to buy failing banks over the next seven years. One of the banks was BoA's massive California competitor, Security Pacific. Amazingly, BoA paid over three times book value for a bank circling the drain. SP shareholders received the equivalent of $41 per share in 1992. Without the buyout, SP CEO Robert Smith estimates the bank's stock would have traded for $4 a share... probably on the way to zero.

As bailed-out institutions live on and grow larger, rescue operations balloon beyond the government's ability to handle alone. The bailed-out become the bailers-out. Bank of America stepped up again in the 2008 crisis and purchased the failing Merrill Lynch for $50 billion, and a teetering Countrywide Financial for $4.1 billion. The purchase of these bad apples continues to cost the company money.

Besides Bank of America, banking authorities asked Wells Fargo and JPMorgan to buy Wachovia, Washington Mutual, and Bear Stearns. With these transactions, Wells and Morgan grew into behemoths that cannot be allowed to fail.

Parsons' most salient point is, "Thirty of what were the 50 largest banks in the country in 1980 are now part of Bank of America, Wells Fargo, and JPMorgan Chase." By the end of last year, the top ten banks in the US now control 56% of banking assets. At the same time, the top 70 banks or 1% of the industry controlled 86% of deposits.

How on earth could stitching a bunch of bad banks together make bigger, safer banks? It can't, no matter what Warren Buffett thinks. Banks made $43 billion in the second quarter only because of a quirk in bank accounting rules that says banks don't have to count the $51 billion they lost in their bond portfolios.

Parsons points out this country has seen 3,000 banks fail over the past three decades and more than 12,000 over the past century. As Rothbard explained years ago, the banking business is unstable and is doomed to repeat a series of booms and busts. Because of that, the financial system would be much safer if its assets were disbursed over as many banks as possible.

Instead, at regulators' insistence, the problems and bad assets of many banks have been combined into a few. Instead of many small problems, we now have a few huge ones.

Systemic risk in the financial system has increased, not decreased. As a result, whenever the next banking crisis hits, it will be a doozy.

Friday Funnies

I'm a sucker for pranks. This one is hilarious:

And this poor anchorwoman never realized she was being pranked:

Lastly, here's a good one from the Onion on Obamacare.

That's It for This Week

Before I sign off, I'd like to draw your attention to a few good watches for the weekend:

  • Doug Casey was recently interviewed by Russia Today. He discussed soaring worldwide debt levels, derivatives, and more. Slide to the 8:00 mark to go directly to Doug's interview:

    As a shameless plug, if you want to listen to Doug Casey, Rick Rule, Jim Rickards, John Mauldin, and other investment legends share their economic outlooks and favorite investment ideas, click here to order the audio collection from our just-concluded 2013 Casey Research Summit. It contains 27 hours of information-packed presentations from our Summit which, based on attendee feedback, was among the best we've ever hosted. And that's really saying something.
  • Lastly, I just received word that our Casey One Pass service is open for a limited time to new subscribers. Casey One Pass is a new way to subscribe to all of our monthly newsletters at a deep discount. You get eight products—including our precious metals, technology, energy, big-picture investing, and income letters—for one low price.

    As they say, there's always a bull market somewhere (in fact, right now, we're seeing great opportunities to profit in all of our sectors), and the Casey OnePass lets you catch them all… for a total savings of $2,141 off the newsletters' combined list prices.

    I think that's huge, but don't take my word for it. Click here to read about the many benefits of Casey One Pass for yourself. If you're interested, act now: the offer expires in less than a week at the end of October.

With that, I'll leave you to enjoy your weekend. Thanks for being a Casey Research subscriber!

Dan Steinhart
Managing Editor of The Casey Report