Tuesday, March 04, 2008
This article starts out sounding a cautionary note about doing derivatives transactions with hedge funds:
"The problem with banks and brokers buying credit protection from hedge funds is that you just don't know when they are going to go dark, turn out the lights and say this is now the brokers' problem," says David Lippman, a managing director of Metropolitan West Asset Management, a bond manager in Los Angeles.
Unlike most other big players in the swaps market, hedge funds aren't subject to heavy oversight by regulators or capital requirements. Financial firms usually guard against the risk of their hedge-fund trading partners being unable to pay by requiring they put up cash or collateral for their swap trades.
Yet, somehow, the banks and dealers seem to be the ones playing all the tricks:
The legal cases underline the gridlock that can emerge when such insurance agreements break down. One suit, filed Feb. 14, outlines a credit-default-swap agreement in which Citigroup bought $10 million of protection against a security backed by subprime-mortgage assets from a small Florida hedge fund with just $58 million in capital. The security was a "collateralized debt obligation," known as a CDO, or a thinly traded investment that packages pools of loans.
The fund -- VCG Special Opportunities Master Fund Ltd., which is owned by an investment firm that also owns a Puerto Rican investment bank -- alleges that Citigroup breached its contract after the bank demanded the fund post additional collateral. By this January, the hedge fund says, the collateral Citi sought from it nearly equaled the $10 million "notional," or underlying, amount of the swap.
In the other suit, the hedge fund, which at that time was named CDO Plus Master Fund Ltd., says it sold credit protection on a mortgage-related security to a unit of Wachovia last May, only to be asked to pony up millions of dollars of collateral in the ensuing weeks.
The hedge fund entered into a credit default swap with Wachovia under which the bank bought protection on a $10 million security issued by a CDO, which had a credit rating of double-A and was issued in April 2007.
Over the next several months as the mortgage market swooned, Wachovia repeatedly demanded the hedge fund -- which had put up an initial $750,000 -- deposit additional collateral for the swap. The hedge fund said in the suit it made more than a dozen additional payments, totaling roughly $8.2 million. In late November, Wachovia requested still more margin, which the fund said brought the total it was asked to fork out to $10.4 million.....
...When one hedge-fund manager considered selling out of a credit-default swap -- in which his fund bought protection on $10 million of bonds of Countrywide Financial Corp. -- he says there was a condition attached by two securities firms. He says the firms -- Bear Stearns Cos., which sold him the swap, and Morgan Stanley -- told him they would cash him out of his profitable position, only if he would simultaneously enter into another swap-selling insurance protection on the bonds equal to his fund's $3 million profit.
As alleged, and If this CDS was written on the standard form, this is an unacceptable 'cram-down' by the street, violating industry practices. Unfortunately, there is this thing known as the 'reference instrument' (not necessarily "entity", contra Wikipedia) in a Credit Default Swap that, to me, leaves some wiggle room for the dealer when things get really tough. Anyone who thinks things aren't really tough for dealer balance sheets right now isn't in the fixed market. More to come, I think.
Can we lay this at the door of the deregulation hawks. It seems that times like these always make us rue the exuberance of times like those. I know all these fine financial instruments are supposed to improve efficiency, but I wonder sometimes. Is it inevitable that as the the complexity of these arrangements increases, the possible modes of failure increase beyond our ability to forecast or regulate? Or maybe this was really a good thing? The banks had a way to stave off collapse in the short term.
I'm really out of my depth here, but what leverage did the bank have to extract more collateral from the hedge fund?
What does deregulation have to do with it? These are big boys playing with big money. They don't need regulating. If they can't handle one of their financial contracts going south, let them fall. If I were that hedge fund, I'd have fought the demand for more collateral.
I'm all for letting these guys suffer. The problem is that when enough of them screw up in the same way, you get the falling dominos, and then it hurts all of us. The purpose of financial regulation, other than preventing fraud, is to make sure that these collapses happen slowly, randomly, without collateral damage. You have to balance the longterm welfare of the financial system, that is the moral hazard issue, against the short term issue, which is panic.
Take for instance embezzlement. The biggest problem is not that you are losing the money, but that it will be discovered all on a single day. That's what happened with Jérôme Kerviel at SocGen. The bank could have dealt with a problem where they were losing the same amount over a year, but losing it without knowledge of it and finding out suddenly can cause a failure of confidence, a bona fide crisis, where the national financial system was at risk of collapse.
I never could understand why banking and insurance used to be separate, but I think this event may provide part of the answer. The lesson that I'm taking from it is that financial instruments can interact in strange ways to create unstable situations, situations that can lead to sudden changes that ripple through the markets, possibly leading to catastrophic damage. I'm not sure if there actually is any solution at all, regulatory or otherwise. Simplicity and skepticism in large doses might help.