GS Goldman Sachs Group Inc

By Liz Hoffman and Andrew Scurria 

Goldman Sachs Group Inc. and Blackstone Group LP recently resolved a monthslong standoff over a controversial derivatives trade that had alarmed regulators and investors in the $11 trillion credit-default swaps market.

The Wall Street giants had taken opposite sides of a bet on bonds issued by home builder Hovnanian Enterprises Inc. The trades, engineered by Blackstone's GSO Capital Partners LP, involved the home builder intentionally skipping a small interest payment earlier this month in exchange for an attractive financing package from the private-equity house.

Blackstone had bought insurance against a default, which would allow it to make money from the skipped interest payment. It bought this insurance, through what are known as credit-default swaps, from Goldman and others. This put Goldman at risk of losing money.

Goldman and Blackstone last week effectively zeroed out the trade between them, with Blackstone agreeing to assume Goldman's position, people familiar with the matter said. Goldman is now off the hook for a payout that could have run tens of millions of dollars, and Blackstone reduces its exposure to a wager that has become increasingly fraught.

Investors have howled that the maneuver was underhanded, while U.S. regulators issued a stern warning against "manufactured" defaults, which was widely seen as aimed at Blackstone. Hovnanian had the funds to make the interest payment that it missed and isn't in dire financial straits.

The concern is that defaults engineered for profit could corrupt the $11 trillion CDS market, which serves as a source of investor protection and an informal gauge of the debt issuers' health.

Bloomberg News earlier reported that Goldman had sold its position, but didn't identify the buyer.

The trade was complicated in another way: It pitted Goldman against Blackstone, one of the bank's largest clients. Blackstone paid Goldman $165 million in fees from 2014 to 2016, according to a regulatory filing, and Goldman's private bank funnels clients' money into Blackstone funds.

The trade came up in discussions between Goldman CEO Lloyd Blankfein and Blackstone President Jonathan Gray and in conversations between Goldman's No. 2 executive, David Solomon, and GSO chief Bennett Goodman, a longtime friend, according to a person familiar with the matter.

Credit-default swaps emerged in the 1990s as a way for bondholders to protect themselves against a default. But they soon became an instrument of naked speculation, allowing investors to bet against a company's debt much the way they can sell short its stock. Some blamed them for adding fuel to the financial crisis.

The Hovnanian tussle has raised a new concern among investors and regulators that the market is vulnerable to manipulation. They worry Blackstone's strategy could tempt more corporate borrowers to strike side deals with lenders and skip payments they could otherwise afford to make.

Solus Alternative Asset Management LP, which also sold protection on the Hovnanian bonds, has filed a lawsuit against the Blackstone unit that engineered the trade, accusing it of orchestrating a "sham default." An executive of Canyon Partners LLC, a hedge fund that invests in distressed debt, called the maneuver "unseemly" in public comments last month.

The Commodity Futures Trading Commission warned in April that "manufactured credit events" could "severely damage the integrity" of the market.

That warning, along with a growing chorus of complaints from other investors and counterparties, led Blackstone to reduce the size of its trade, a person familiar with the matter said. Blackstone has said it would support "appropriate changes" to credit-default swap contracts, an acknowledgment of the regulator's concerns.

Write to Liz Hoffman at liz.hoffman@wsj.com and Andrew Scurria at Andrew.Scurria@wsj.com

(END) Dow Jones Newswires

May 24, 2018 13:26 ET (17:26 GMT)

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