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.
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CDS = liar liens. Bought on a “Don’t call, don’t show” basis. Notice how UBS’s claim isn’t actually secured by any identifiable asset: they have to sue even to get within sniffing distance of a measly $4.6M. ‘Pseudo-insurance’ long on pseudo and short on insurance provides no value added except to those who extracted fees for cranking the mill on these things.
Yves: “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?”
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.
The problem probably isn’t lack of disclosure, but rather investors who don’t read disclosure, don’t understand it, or don’t care about the risks disclosed.
“I doubt there’s fraud. UBS’ offering materials probably disclosed that credit risk of the swap counterparty was a risk factor.”
But how can you possibly claim that it is default insurance when in the even of default the likelyhood of payout is pretty much zero?
Or am I missing something?
anon 8:53am: “But how can you possibly claim that it is default insurance when in the even of default the likelyhood of payout is pretty much zero? Or am I missing something?”
As I said before, the disclosure probably says that the investors have credit protection from an undercapitalized entity, so 100% likelihood of payout due to default but only for a small amount of the losses. If investors think that means they have a money good guarantee against 100% of losses, they aren’t reading the disclosure, don’t understand it, or ignore the risks in a hunt for high yield.
Other investors in CDOs actually bought instruments where a bank was obligated to buy the underlying securities at par, regardless of fair market value. If the investors in this particular UBS deal got proper disclosure, they were speculators who gambled and lost.
Apparently, you put $4.6 million in capital, collect 15 bp on $1.3 billion [about $ 2 million a year..] FOR A 43% RETURN ON CAPITAL…and surprise, surprise it was a risky trade.
I’d want to know if those notes had a credit enhancement bump from Moody’s, Fitch, or S&P due to the insurance. There would be some deeper pockets to go after for the investors.
etc….
This is a great example of what happens when the Wizards of Finance types who get all Alpha Male on us and start spouting off those nauseating “Finance is War!” cliches…..
Only, this time our pale, puffy, doughboy warriors were just too damn eager.
See, here’s how problems like this UBS litigation have come about:
This case actually started back in 2003 and 2004. The statue just came a tumbling down. Inspired by Saddam’s fall, one of the Big Swin…urh…let’s just say BSDs of Wall Street, replete with his suspenders and a power tie thought it’d be instructive to get a Former Bad Ass General to come and “speak to the troops”. He figured maybe they’d get access to some of the latest military jargon and that they might construct some kick-ass acronyms. [Unfortunately, they forgot about FUBAR.]
The Former Bad Ass General, now a bad ass $25,000 per gig speaker came, and regaled the troops with anecdotes straight from Sun Tzu. Of course, the troops lapped it up with the gusto of Charlie Sheen in the throes of an all-night keggar party at the Playboy Mansion.
At the end of the speech, during the Q&A, a benign question was posed about managing the troops. The Former Bad Ass General’s alluded to the military’s policy on dealing with gays who’d like to serve our country.
Well, at this point, the machismo was palpable. Barry Bonds, after a 3 week dianabol bender, would have said there was too much testosterone in that room. But these manicured troops were too busy head butting and chest bumping to listen to the entire content of what was a rather mundane comment on the Pentagon’s “Don’t Ask—Don’t Tell” policy regarding homosexuals in the military.
Unfortunately, their truncated version contained just enough info to set off the nuclear chain reaction in our financial markets: They heard the “hom” part of homosexual and they heard something about “not asking and not telling”.
With this military mandate, lightning struck, and EUREKA! The Little War-Lords that Could got it in their heads that they should construct “home” loans in the manner that the military deals with the inconvenient fact that some men are gay….”Why yes, the fact that people cannot pay for these loans is rather inconvenient…so as long as we don’t ask, and they don’t tell, this is going to work beautifully!”
And that’s when it all began….A New Manhattan Project and a nuclear explosion of CDSs, CDOs, AAAs, and mortgage holders with names as obscure as the bar code on the back of this morning’s cereal box…all exploding in a mushroom cloud of irony.
And the Little War-Lords that Couldn’t howled for interest rate cuts and bail-outs…quickly discarding all Dawinian notions Survival of the Fittest in favor of Bernankian’s Unintelligent Design.
To etc:
If you believe there’s no fraud here…and you aren’t a part of the Conspiracy Not to Ask, then you must be delusional.
At some point, active and utter negligence is nothing more than passive fraud
The finance industry is a giant systemic failure and its “Don’t look/Don’t tell” policy breeds a hoard of these passively fraudulent actors. This UBS example, like so many of the subprime mortgage examples, is filled wink-wink “disclosures”, which are given not to inform, but rather to deceive.
Only, the one being “deceived” is actually encouraging the deceit. Self-Induced Fraud? More like a murder by suicide…followed up with the obligatory—“And when do I get to collect my insurance benefits?”
The whole mess is reminiscent of a stupid riddle: If, in addition to the tree falling in the woods, mortgage fraud occurs there as well—is there a sound and is there a deception?
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.
There is a saying in the islands, “when teef (thief) steal from teef, God smile”. I am smiling too.
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.
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.
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???
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.
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.
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).
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.
“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.