naked capitalism

Gretchen Morgenson of the New York Times in “First Comes the Swap. Then It’s the Knives.” delves into a dispute between UBS an Paramax, a Connecticut-based hedge fund group over a credit default swap written by Paramax in 2007 on a subprime CDO (you can already guess how this movie ends).

Morgenson-bashing is a popular sport, so I must note that this article is written almost entirely based on court filings, and Morgenson generally does a decent job with them.

The short form of this sorry tale is that as losses mounted on this dodgy CDO, Paramax stopped putting up collateral as required in the contract and UBS sued. Where this gets interesting is that Paramax countersued, arguing that they had been reluctant to go into the deal and UBS had given them assurances that they would be lenient in marking losses to market.

What surprises me is that Morgenson doesn’t make more hay about what seem to be an obvious fraud perpetrated upon the investors. UBS used a hedge fund group with only $200 million in equity to insure a $1.3 billion deal, and the hedge fund did do via a special purpose entity with only $4.6 million in equity.

Note further that most hedge funds have formal or informal limits as to how much of the fund’s total assets they can put at risk in any one position; for most, it’s 5% or less; 10% would be a very high number. Yes, you can argue that the risk insured was the super-senior tranche, and therefore very low risk. But the maximum amount you can assume that Paramax would be willing to part with would be $20 million (maybe $40 million if you assumed some gearing, but as the case proves, Paramax was good for only a bit over $20 million). That’s only 1.5% of the value of the instrument. Thus, it was clear from the outset that the insurance was fraudulent. But UBS was clearly well aware of Paramax’s limits, so the next question is: was UBS solely responsible for pulling a fast one on the CDO buyers, or is Paramax a co-conspirator?

Experts expect increasing credit problems leading to disputes over the enforceability of credit default swaps contracts. Many are likely to hinge on ambiguities in contract language rather than side assurances, as the UBS/Paramax case does.

But since over 30% of the credit default swaps were written by hedge funds, many of whom were probably as incapable as Paramax of performing in the event of a default, it’s not unreasonable to assume that some of these CDS lawsuits will lay the foundation for investor litigation.

From the New York Times:

Investors don’t often get a peek inside the vast, opaque and unregulated world of credit default swap…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…

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.