Re: [Pen-l] What cooked the world's economy?

[raghu <mraghu01@xxxxxxxxx>]

On Wed, Jan 28, 2009 at 5:22 PM, John Gulick <john_gulick@xxxxxxxxxxx> wrote:
> I still don't get exactly how the hedge funds got tied up with credit
> derivatives and made mega-profits from the credit derivatives.
>


Considering the number and diversity of the hedge fund universe, I don't think we can identify one simple mechanism common to all (apart from the general truism that each and every single one of them existed so they can make money by gaming the system in one way or another, which makes them fraudulent enterprises by design).

We can however identify some patterns (or MOs).

(1) some hedge funds sold insurance in the form of CDSes they never intended to (and didn't have the ability to) pay out. This was a pure swindle of their own investors: the managers simply collect the premiums in the good times, and shut the fund down when things turn bad.

http://www.econbrowser.com/archives/2005/11/hedge_fund_risk.html

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> CDP stands for "Capital Decimation Partners", a hypothetical fund created by Professor Lo in order to illustrate the potential difficulty in evaluating a fund's risk if all you had to go on was a decade of stellar returns. The strategy whereby CDP would have amassed a hypothetical fortune was amazingly simple-- it simply sold put options on the S&P 500 stock index (SPX). [...]
> But what about the person who sold you that put? They have now assumed all of your downside risk. Lo's Capital Decimation Partners would use its capital to meet the margin requirements (which guarantee to the exchange that CDP could in fact make the payments to the buyer of the put), and roll over the proceeds to make even bigger bets. Essentially it was thus using leverage to turn the relatively small proceeds from selling these puts into a huge return on the capital invested.
> Of course, if you play that game long enough, eventually the market will make a big enough move against you that your capital used to meet margin requirements gets completely wiped out, giving you a long-run guaranteed return on your investment of -100%. But over the 1992-99 period, Lo's hypothetical fund dodged that bullet and ended up turning in a whopping performance.

(2) Some hedge funds sold fake insurance products basically intended to help companies cook their books. See for e.g.:

http://www.nakedcapitalism.com/2008/06/ubs-cds-lawsuit-harbinger-of-things-to.html

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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. 

(3) some funds used derivatives to help banks circumvent regulatory constraints. AIG in particular did this on a massive scale:

http://paul.kedrosky.com/archives/2008/09/30/how_the_us_save.html

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> The K-10 annex of AIG's last annual report reveals that AIG had written coverage for over US$ 300 billion of credit insurance for European banks. The comment by AIG itself on these positions is: "…. for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee". AIG thus helped to organise regulatory arbitrage on a gigantic scale.

(4) at the moment of course the big game for financiers is to steal some government bailout money for themselves. Some of their tactics are repugnant even by the low ethical standards of the financial world, see for e.g. where a fund manager is arguing that his losses amount to a human rights violation:

http://www.telegraph.co.uk/news/newstopics/politics/lawandorder/4365547/Hedge-funds-use-human-rights-laws-to-make-money.html

----------------------------------------------snip

Earlier this month, hedge funds RAB Special Situations and SRM Global Master Fund, were part of an action in the High Court arguing that the nationalisation of Northern Rock had deprived them of their property (the value of Northern Rock shares they owned) and was therefore in breach of the Human Rights Act.

-raghu.

--
Did you hear about the dyslexic Satanist? He sold his soul to Santa.

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