He Said, She Said

I'm no lawyer, but I'm assuming that the outcome in some legal proceedings rests on the resolution of a "he said, she said"-type conflict.

In other words, the judge or jury has to figure out which one of the two parties involved in a case is telling the truth. I'm thinking it comes down to how those individuals present themselves, what they might have said or done in the past, how much detail they provide, etc.

On that basis, given all the reports we've seen and heard since the Great Unraveling began, I have to say I'm pretty confident about which party is probably to blame in the following story from the New York Times' Gretchen Morgenson, "First Comes the Swap. Then It’s the Knives." (hint: it's not the customer).

Investors don’t often get a peek inside the vast, opaque and unregulated world of credit default swaps, those privately traded insurance contracts that essentially allow participants to bet on or against a debt issuer’s financial condition. (Remember, these are the same instruments that played such a pivotal role in the collapse of Bear Stearns.)

But the legal battle between UBS, the Swiss investment bank, and Paramax Capital, a group of hedge funds in Stamford, Conn., is giving investors a gander at how this freewheeling market works.

The view is instructive, given the unknowns in the huge and growing credit default swap market and the unease about its potential to wreak havoc on the financial system. Experts say the legal case is also the first of what will probably be a flood of disputes between the big banks and hedge funds that typically strike swaps deals.

Like a homeowner’s policy that insures against fire or flood damage, credit default swaps are intended to cover losses to banks and bondholders when companies that have issued debt are unable to pay it back. The nominal value of the insurance outstanding is now $62 trillion, up from $900 billion in 2000.

Although this figure, also called the notional amount, overstates the risk in the market to a degree, such swaps do promise to make up for losses that result if a borrower defaults. And that risk is real — as well as very, very large.

There is no central market where investors can watch credit default swaps trade and see their prices. Each transaction is conducted away from regulators’ prying eyes. While there are common aspects to many of these contracts, so-called bespoke deals also exist, hand-tailored to the requirements of the parties involved in the transaction.

The swap that is central to the UBS-Paramax dispute is one of these customized deals, dating from May 2007, well into the mortgage crisis. The swap was created to insure $1.31 billion in highly rated notes that reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS.

The swap insured these notes, known as the “super senior tranche” of the debt obligation, because they were rated triple-A by both Standard & Poor’s and Moody’s Investors Service.

Officials at Paramax declined to comment on the litigation and the swap that led to it. A UBS spokesman said the company “is confident in the merits of our case.”

According to the story that unfolds in the court documents, in early 2007, UBS approached Paramax, a small hedge fund with just $200 million in capital, to insure the notes. After months of discussion, Paramax established a special-purpose entity to conduct the swap and capitalized it with $4.6 million.

Under the terms of the deal, UBS would pay Paramax 0.155 percent of the $1.31 billion in notes annually for its insurance and Paramax would deposit collateral to back the swap, increasing it if the value of the underlying notes declined.

That they did. Almost immediately.

By early November, UBS had asked Paramax for $33 million in additional collateral. Paramax refused, and UBS sued the fund, contending breach of contract, in mid-December 2007 in New York State Supreme Court. Paramax filed a counterclaim in January.

In court filings answering the complaint, Paramax tells its side of this story — and intriguing it is. The fund said it knew when it entered into the swap with UBS that the swap was risky and could require a good deal more capital than it had to deploy if the underlying securities fell in value. Paramax was concerned, the court filing said, that UBS could mark to market downward the value of the notes, causing a call for more collateral beyond the initial $4.6 million.

To allay the fund’s concerns, the documents say, Eric S. Rothman, the UBS managing director who arranged the deal, assured Paramax that mark-to-market risk was low. During a Feb. 22, 2007, phone call, Paramax contends in the filing, it was informed by Mr. Rothman that “UBS set its marks on the basis of ‘subjective’ evaluations that permitted it to keep market fluctuations from impacting its marks.” The filing also says: “Rothman explained that he was responsible for all marks on UBS’s super senior positions and that he could justify ‘subjective’ marks on the Paramax swap because of the unique and bespoke nature of the deal.”

Mr. Rothman is no longer employed at UBS. He could not be reached for comment.

In later discussions, according to court documents, Mr. Rothman contended that even if significant defaults arose in the underlying mortgages, UBS’s marking of the position “might not be as bad as you’d first think.”

On April 10, the hedge fund’s filing said, Mr. Rothman pressed Paramax to “please close this trade already”; in mid-May, the hedge fund pulled the trigger on the deal.

Six weeks later, in early July, Paramax said, it received its first margin call from UBS, for $2.36 million. On Aug. 10, UBS asked for an additional $12.7 million in collateral from Paramax and, on Aug. 22, called for almost $14 million more. The margin calls added up to almost $30 million, more than six times what Paramax had posted in initial collateral.

PARAMAX subsequently arranged with UBS to substitute the credit default swap with a restructured note that would not generate further margin calls. Based on those discussions, over the summer Paramax supplied UBS with $29.3 million to cover the margin calls.

But UBS submitted another margin call to Paramax in November, which the hedge fund declined to cover. Paramax contends in its filing that UBS’s margin calls exaggerated changes in the market.

On Dec. 10, UBS announced that it would take a $10 billion write-down in the fourth quarter of 2007, much of it related to “super senior” holdings like those it had insured with Paramax. Three days later, UBS advised Paramax that a default had occurred in the notes Paramax had insured. In December, after failing to reach a settlement with Paramax, UBS sued the hedge fund. Paramax responded by filing a counterclaim, asking that UBS return the $33.9 million that it lost in the swap.

John P. Doherty and Richard F. Hans, law partners at Thacher Proffitt & Wood, argue that the UBS-Paramax case is only the beginning of lawsuits relating to credit default swaps.

In “The Pebble and the Pool: The Global Expansion of Subprime Litigation,” an article published this year by Thomson West, they wrote: “In addition to losses resulting from corporate default on the underlying loans or bonds, the credit default swap market may also feel stress from the repricing of risk following the deterioration of corporate and/or household credit, as well as a rise in corporate bankruptcies stemming from the subprime market failure.”

The credit default market has ballooned recently, at least in part because of low default rates on corporate bonds. In such a benign environment, participants may have had little concern about the solidity of the entity agreeing to insure, known as the counterparty, or about problems with the swaps’ performance.

Those days are over. And as defaults rise, the optimistic assumptions are likely to come up short. But learning about the details of these disappointments will surely be educational.

Comments

[harleydog]

Mike

Don't know if you read FIASCO, a book which came out a few years back by a couple of Morgan derivatives guys, if I remember correclty. Talks about all the esoteric and exotic deirvatives tailored for each specific client. EZ to get into hard to get out.

HD

[dearieme]

I must have misunderstood this story. How can a tiny wee company insure a huge investment, at an enormous bank, against losses?

[Ed H]

This is a great find and I have written a post on my blog referring back to it. These bankers and hedge fund managers are fighting for their economic lives. You better believe the long knives are out. Obviously, credit writedowns are at the heart of this story. I am cataloging those writedowns by institution in order to create a comprehensive overview of what the likes of UBS face. It's daunting: well over $350 billion in credit writedowns and counting.

http://www.creditwritedowns.com/2008/05/credit-crisis-timeline.html

[Jes]

WOW! Great post!

[Lawrence Loeb]

Interesting that UBS went to such a small firm to write their insurance.

I just posted an item on my blog that points to a Moody's report explaining the CDS market and its risks (http://blog.lawrencedloeb.com/2008/06/great-primer-on-credit-default-swaps.html).

Morgenson's mention of the $62 Trillion notional value (which she, for some reason, chose to call nominal) way overstates the risks associated with the market. As I explain in the post, notional is a fairly meaningless number.

If you buy an option to purchase 300 IBM shares at $150 per share at a cost of $75 ($0.25 per share), you have a position with a notional value of $45,000!

Notional is just the face value of the assets underlying the derivatives contract.