With the Argentine default, we are seeing a replay of a strategy that established Naked Capitalism readers will remember from the crisis: use a complex structure to disguise risk so that short sellers can place their wagers at far lower prices than they would be able to otherwise. And that raises the interesting question of how large a net short position Paul Singer, the instigator of the litigation that has undone Argentina’s restructuring deal and put the country in default, took against Argentina, as well as the relationship among the parties that put on the positions on behalf of short sellers.
As we’ve discussed regularly on the site, and longer form in ECONNED, the main mechanism that famed subprime shorts like Magnetar and John Paulson used were synthetic and heavily synthetic CDOs. That means their “assets” were mainly or entirely the credit default swaps that were these short sellers’ bets against risky tranches of subprime mortgage bonds. By packaging them into CDOs, they were able to sell BBB risk at close to AAA prices (the AAA tranches of CDOs did carry a higher yield than conventional AAA investments). The really drecky remaining tranches were flogged to clueless investors or rolled into other CDOs.
We now see tales emerging of who were the bagholders on the Argentina CDS, as in who were the “protection sellers”. Although the deal structure was different, the general pattern is the same: use a complex credit instrument to shift risk onto naive buyers. FT Alphaville yesterday described one victim, a sole investor in a credit-linked notes deal that provided a premium yield in return for taking on Argentine default risk. The result was that the investment has taken 51% losses. Today, the press seems to have identified the victim. From Bloomberg:
Brazilian postal workers became unlikely victims of Argentina’s default last week after a $168 million fund used by their pension plan recorded a loss on most of its assets.
The fund operated by Bank of New York Mellon Corp (BK:US).’s local unit wrote down its value by about 51 percent after losses on securities linked to Argentine government debt, according to a regulatory filing yesterday. While the statement didn’t identify the entity that is the fund’s sole investor, all signs point to Postalis, the pension manager serving about 130,000 current and former postal workers in Brazil.
Postalis, which had 8 billion reais ($3.5 billion) in assets according to the latest data available, said in statements as early as 2011 and as recently as May that it had invested in the fund. Postalis’s press office declined to comment/blockquote>
Derivatives expert Satyajit Das explained via e-mail who the stuffees were:
· A lot of riskier (including emerging market) debt has been repackaged for retail (in the main high net worth and private banking client) in the ubiquitous “dash for trash”.
· So major dealers were intermediating CDS between hedge funds, institutions and banks (hedging inventory or underwriting risk), where the credit linked note buyers were taking on the risk from the forenamed parties.
· Typically the structuring dealers do not take much warehousing risk, though there can be timing lags.
· My understanding is there are around US$31 billion in CDS outstanding on Argentina (the US$ 1 billion that is spoken about is the net in the dealer/ bank system). I imagine a significant amount of the Argentina risk therefore found its way to retail and private banks, who now face prospects of loss. My understanding is that the holders of risk are mainly in Asia and Europe as well as South America, including banks, investors and also possible official institutions.
What makes the Brazilian pension fund case noteworthy was that these notes weren’t slipped into the portfolios of unsophisticated rich people. It was instead offloaded onto a government pension fund, which one would hope has better controls and oversight. However, experience in the US shows that that is often wanting. As NC contributor Michael Crimmins pointed out, the postal workers had already been defrauded before the large losses added insult to injury (emphasis his):
First the fund was massively defrauded in the original transaction by their portfolio manager. who sold them the credit-linked notes.
Then currently, they are the bagholders for a CDS written on Argentine debt that was part of the original structured notes .
The investment linked to Argentina’s sovereign debt was made in December 2011, when the fund was managed by Atlantica Administracao de Recursos Ltda., according to the [SEC] filing. BNY’s Brazilian fund unit took over management in March 2012.
Bony took over the management after the original managers Atlantica Administracao were found to have defrauded two Brazilian public pension funds and a Colombian institutional investor that purchased from LatAm the structured notes issued by major commercial banks.
According to the SEC’s complaint against Neves and Luna filed in U.S. District Court for the Southern District of Florida, Neves negotiated with several U.S. and European commercial banks to structure 12 notes on his customers’ behalf from 2006 to 2009. But instead of purchasing the notes for his customers’ accounts for prices around the banks’ issuance amounts – which totaled approximately $70 million – in most transactions Neves first traded the notes with one or more accounts in the name of offshore nominee entities that he and Luna controlled. Neves then sold the notes to his customers with undisclosed markups as high as 67 percent. Neves had no reasonable basis to mark up the prices that significantly.
For a full description of the fraud involving these notes see here
The deals involved in the Brazilian and Columbian pension funds were structured by Commerzbank, Lehman, JPM, and Barclays.
So there was at least one dumb captive fund writing CDS for the commercial banks.
I suspect they weren’t the only ones.
Crimmins also points out that Argentina’s allegations of collusion aren’t unreasonable:
We’ll have to keep our eyes on the Argentine investigation into Eliot’s [Paul Singer’s fund’s] trading to see if a pattern emerges whereby the holdouts worked with the banks to cover their bets and then used the courts to force a default.
It’s a good arbitrage play. Use the courts to force full payment on the bonds v use the courts to force a default event to trigger the CDS.
These deals were being structured during the same period as the MBS deals and have a similar smell.
Indeed. Stay tuned