Mar. 4th, 2008

peterbirks: (Default)
There have been a couple of interesting articles in the US in the past couple of days on the bond crisis/liquidity crunch.

The Wall Street Journal highlighted the darker side of the scene pre-disaster. A $58m hedge fund (i.e., peanuts) is suing Citigroup and Wachovia because it claims that it was "suckered".

Now, I have no sympathy whatsoever for the plaintiff in this case (VCG Special Opportunities Master Fund Ltd). But the details of the case make interesting reading.

Last year the hedge fund (which had a habit of changing its name, btw) sold credit protection on a $10m CDO mortgage-related security to a unit of Wachovia. This got the security off the books of Wachovia. Since the hedge fund had $58m of assets, I dare say Wachovia booked this $10m as "safe" money (i.e. Wachovia assessed it at 0% risk of counterparty default).

The hedge fund, meanwhile, wrote the protection because it looked like easy money. Although it was a $10m policy, it only had to put up $750,000 collateral for the swap. That translates into a healthy return on your money for taking a risk off Wachovia's books that was probably triple A rated.

Indeed, like writing put options, it's easy money until things go wrong. Doubtless there have been hedge funds doing this for years.

But, when things go wrong, Wachovia wants more money, more collateral. The hedge fund doesn't have the collateral (and neither can it borrow it in the money markets, because there's a credit crunch). Wachovia, which is within its rights here, then seizes back the security in the financial equivalent of a foreclosure. Result, hedge fund does its bollocks and Wachovia gets a toxic security at a discount (probably a price roughly equivalent to its real value).

Now, hedge funds provided about 33% of all the trading volume of credit derivatives in 2006, which I reckon equals about $15 trillion in deals being made by hedge funds, many of them as small as VCG Special Opportunities Master Fund Ltd. The excuse of Donald Uderitz of VCG is that he didn't think that there was any likelihood of the insurance that he was providing having to be paid out. He put up the $750,000 collateral expecting to earn $275,000 in fees from Wachovia. He now claims that Wachovia "suckered" him.

Well, er, duh. If you are a hedge fund trader who happens to be an idiot, then you will eventually lose money. That's how it works. Anyone who thinks that you can generate returns of 33% on a certainty needs his head examined.

Another claim by the hedge fund managers is that if they have a derivative position that is in profit, the investment banks won't pay them off unless they take out another position. Well, unlucky. The hedge fund managers are confusing the market value of a product with cash. Something is only equivalent to cash if a counterparty is willing to pay you cash for it. The investment banks are perfectly within their right to point out that derivatives have a termination date at which the true value becomes known (the same with every future). Trading of those derivatives before the termination is not compulsory. It might look like a liquid market, but that liquidity can vanish, at which point you are stuck with the product until the date it closes. If your business model depends on futures retaining liquidity for trading in the here and now, then your business model is dodgy.


Finally, the bond insurance industry strikes me as being somewhat disingenuous when they start talking about the future. It's all very well Ambac and MBIA starting to talk about focusing on the muni sector, but if your credibility is fucked, why should states bother?

Rumour has it that MBIA just isn't writing new business at the moment. California, meanwhile, has a $1.75bn issue coming up that has no bond insurance. California spent more than $100m insuring its bonds between 2003 and 2007. For its last three bonds it has spent nothing. California state treasurer office spokesman Tom Dresslar said that "it would be a waste of taxpayer money".

Arbitragers cannot fail to have notice that in recent weeks there have been cases of identical bonds being cheaper if they carry insurance, which is a bit like rating 97 offsuit above 97 suited.

But there is a good reason for the states not to pay for bond insurance. That reason is that, if the market doesn't think that the triple A rating supplied by a bond insurer is "transferable" in time of need (as has been shown to be the case in the CDO market) then there is absolutely no point in paying extra for it.

In that sense, any attempts by the bond insurers to move back to the old safe muni area is doomed, because few of the counterparties value what the bond insurers think that they have to offer.

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