Comments on: UBS CDS Lawsuit: Harbinger of Things to Come?

By: Ginger Yellow

Ginger Yellow — Thu, 05 Jun 2008 13:47:00 +0000

“The math certainly fits your theory (ie, the capitalization of the SPV fits), but (forgive asking a dumb question) was having a third party take a 3% first loss position considered adequate for an AAA? “

In May 2007, certainly. The expected loss for a AAA super senior tranche is (was) effectively zero. And bear in mind that the triple-A tranches of the ABX didn’t fall significantly until quite late in 2007, and those don’t differentiate from naked AAA and super senior.

By: jck

jck — Mon, 02 Jun 2008 11:51:00 +0000

Yves:
In one of their conference calls, UBS explained that this was one of their way to hedge super senior swaps, unloading a 3/4% expected loss tranche on an outside party.
At the time it looked like the right thing to do and confortable enough, remember on a high grade CDO, the super senior attachment point is as low as 11% so if you move it to 14/15 you think you are OK…I also think the note in default is not the super senior itself but something below it and that triggers a margin call, as cedit cover is reduced.

By: Yves Smith

Yves Smith — Mon, 02 Jun 2008 08:02:00 +0000

jck,

The math certainly fits your theory (ie, the capitalization of the SPV fits), but (forgive asking a dumb question) was having a third party take a 3% first loss position considered adequate for an AAA? Hindsight is always 20/20, but that now looks pretty foolish, and would seem to be aggressive even at the time (things were looking wobbly in 2007).

By: jck

jck — Mon, 02 Jun 2008 07:43:00 +0000

Doubtful that they are on the hook for $1.3 bn. Most likely, [ I am guessing] this is an expected loss tranche so they are on the hook for some fixed portion, maybe 3%, they put 1/10 of that as capital and they are working [again just guessing] with about 300 to 1 leverage, hence the high return, but of course it’s not risk-free, they knew it, they paid up all margin calls except the last one.

By: Shawn H

Shawn H — Sun, 01 Jun 2008 21:37:00 +0000

To understand the motivation, you need to follow thru with daveNYC's logic. The Hedgie wants long-term risk (OPM at risk) for short-term paper (M2M) gains (Hedgie profit).

Hedge Funds only share in the upside, not the downside. So they want a product that will pay above market return for a few years, even though it is known by both broker and hedgie to be worth 0.

First few years, the hedgie gets paid 1% of capital and 20% of ****PAPER*** gains. Once the losses hit, who gives a rat's ass, the hedgie is off to the Hamptons for a year, then will start a new commodities swaps fund.

By: binaryoptions

binaryoptions — Sun, 01 Jun 2008 21:10:00 +0000

NYT said $33.9 million that it [Paramax] lost in the swap.

But isn't Paramax on the hook for the entire 1.3 billion notional value? And the collateral is just less that 3% of the notional? Why so small?

And as JCK correctly pointed out, Paramax was looking at a 43% return initially. Is there something wrong in this picture? A 43% return on AAA debt???

By: daveNYC

daveNYC — Sun, 01 Jun 2008 19:22:00 +0000

I doubt there's fraud. UBS' offering materials probably disclosed that credit risk of the swap counterparty was a risk factor, that the swap counterparty was a thinly capitalized sub of Paramax, and the limited circumstances (if any) in which Paramax would have to provide credit support to the sub.

Bah, there's counterparty risk in the form of 'Allstate might go broke, leaving me with no hurricane insurance.' and risk in the form of 'We know that the guys we bought insurance from don't have the cash.'

I like the hedge's chain of events:
Hedgie: This looks pretty risky.
UBS: No it isn't.
Hedgie: You sure?
UBS: Yep, and I'll even be willing to fudge the mark-to-market price to help you out.
Hedgie: OK.

By: ruetheday

ruetheday — Sun, 01 Jun 2008 19:20:00 +0000

I agree with Richard Kline’s first post. The whole CDS market is a pseudo-insurance racket with emphasis on the pseudo part. If some financial firms want to play insurance company without the typical regulations that govern the behavior of real insurance companies, and sophisticated investors (e.g., hedge funds) want to buy this fake insurance, fine. When the “policies” get tested, let the “underwriters” go bankrupt and let the CDS buyers eat the remainder of the loss without coverage. Who cares. The only caveat is – do not allow commercial banks to play in the CDS market and do not allow them to loan money to speculators.

By: Anonymous

Anonymous — Sun, 01 Jun 2008 19:03:00 +0000

There is a saying in the islands, “when teef (thief) steal from teef, God smile”. I am smiling too.

By: etc

etc — Sun, 01 Jun 2008 17:09:00 +0000

Kudos to jck; looks as if s/he’s right, that Paramax gambled and lost.

It looks as if 2 Paramax entities have exposure to UBS: Paramax Capital International, which provided credit production under the CDS with UBS, and Paramax Capital Group II, which guaranteed payments owed by PCI under the swap. UBS filed suit against both for breach of contract. Since UBS didn’t trust PCG II with discretion to cover PCG II’s swap obligation under an unenforceable comfort letter, it is odd that Paramax trusted UBS with discretion over MTM. I guess Paramax thought the risk was worth the extra yield, like the investors.