Tuesday, March 4, 2008



In a page C1 article today entitled “Swap Skirmish: Risks Hidden, Says Hedge Fund,” The Wall Street Journal reports that hedge funds are suing their counterparties in credit default swap trades, primarily banks and investment banks, for (gasp!) asking those hedge funds to fulfill their obligations under the contracts underlying the swap trades. The nerve!

The Journal specifically cites a small ($58mm in capital) Florida hedge fund, variously named VCG Special Opportunities Master Fund, Ltd. or CDO Plus Master Fund Ltd., which is suing Citicorp and Wachovia for having the temerity to ask for additional collateral when the swaps that VCG/CDO wrote didn’t work out for the hedge fund. Donald Uderitz, VCG/CDO’s manager says that he believed that there was little likelihood of having to make good on the contracts when he entered into them and that he bought the investment to earn the fees Citi and Wachovia would pay his fund (ranging from 275 to 550 basis points) for effectively insuring them against loss on the underlying position. Mr. Uderitz’s statement, and lawsuit, amounts to arguing that he’ll take the fees when things go his way but can’t be expected to make good on his obligations when things don’t. After all, as the Journal reports, he thought that there was little likelihood of actually having to make good on the contract when he entered into it, and what could be more controlling than the judgment of a barely post-pubescent hedge fund manager? (I have no idea how old Mr. Uderitz is, but he is not the only hedge fund trying to welsh on its obligations under credit default swaps, and many hedge fund managers, into which we have entrusted large swaths of our financial markets and economy, are indeed barely post-pubescent. But I am sure they are sharp, really sharp, rowed crew at Yale, and came from very good (i.e., wealthy) families, which is all that matters anyway. But I digress.) Hey, they thought it was all a game. Can’t they just go home and have mommy, perhaps Mother Ben, kiss it and make it all better?

The case of the hedge funds’ suing their counterparties is another case of “a plague on both your houses.” Why in the world did the reputedly responsible Citi, Wachovia, and any number of other venerable financial institutions feel comfortable buying default swaps (effectively insuring against credit losses on instruments they held or in which they were speculating, either directly or indirectly) from obscure hedge funds with microscopic capital bases? Who approved such an arrangement? The sycophantic clown who calls himself the “risk manager?” The CEO in a hurry to make his appointment with Muffie on the company yacht? The guy who runs the cafeteria?

This reminds me of two stories, or perhaps one extended story from my personal experience. Several years ago I was having dinner with some friends. There was a guy at dinner whom I have met on several occasions but whom I didn’t, and don’t, know well. He was running a hedge fund at the time. Not having access to his books, I didn’t know how big the fund was, but, from what I did know of the guy, I would guess that his capital base was even smaller than the aforementioned VCG/CDO, probably considerably smaller. At the time, I knew next to nothing about credit default swaps and knew he was active in them. I wanted to learn more about them, so I engaged him in conversation. He was eager to talk to me because he had written swaps on some of the car companies and he knew that I knew (and know) something about the car companies and had made a dollar or two trading their common. He informed me that he had written scores of millions (He’s not the kind of guy who uses terms like “scores of millions;” I am trying to avoid being too specific here.) in credit default swaps on one of the car companies that had been given up for dead but about which I was more enthusiastic than the market. Given my lack of experience with credit default swaps, I asked him for clarification, asking something like “So if (name of the car company) defaults, you have to come up with (scores of millions)?” He replied “Yes.” I replied “Just asking, but where are you going to come up with that kind of money?” Trying to avoid banal discourse, I refuse to use the term “deer in the headlights,” so let’s just say he looked like Tom (of the famous “Tom and Jerry”) when the maid came home from a Saturday night bridge game (after a call from Jerry, of course) to find Tom partying with his various alley cat pals. My dinner companion looked as if he had never considered actually having to make good on his obligations, and certainly didn’t have enough money to do so. I wondered how thoroughly his counterparties had vetted his ability to pay. The conversation ended, but my curiosity didn’t. I asked several people familiar with the credit default swap market about controlling counterparty risk, and none had a very good, or reassuring, answer. This situation, as you might guess, added to my even then growing consternation about the solidity of our financial system.

Several weeks later, I was discussing this situation (while omitting names) with my brother, who is not a financial guy and who has more innate intelligence than just about anybody I know. He asked a very good question: “Mark, why don’t we go out and write a bunch of these contracts, take the fees, and then close up shop? We could make a fortune!” If we had maybe a few more bucks and the ethics, cluelessness and figurative potvaliance of your average hedge fund trader, I suppose we could have. Oh, well…yet another example of that damn prudence and those blasted ethics getting in the way of a golden opportunity!


Brian said...

Reading that story makes me even more scared of Default Swaps than I was before, and believe me, I was scared before.

--The amount of outstanding futures contracts is valued at $683.7 trillion-- according to the BIS in Nov. 2008

Global Assets are valued at $75 trillion

Uh... ?

It's enough to make you laugh and cry at the same time

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