UBS Breaks Heart of Trusting Hedge Fund

This is amusing. We won't even pretend to fully understand how credit default swaps work, nor are many people consumed with a desire to find out on this delightful weekend.

But it's important, so this is the equivalent of broccoli for your life, in that when some financial meteor next hits, you won't be reduced to blaming Freemasons or Bush and his oil friends (and who are these oil people anyway that are supposedly the puppet masters behind each and every Bush act, from sneezing to invading Iraq? Don't answer because you don't know).

The N.Y. Times presents to us a deal between two parties: big bank UBS and a hedge fund firm named Paramax which had about $200 million in capital. UBS wanted to insure $1.31 billion in highly rated senior notes, and Paramax said "Gee sure, we will set aside $4.6 in our special purpose "entity" and insure you. You convinced us!"

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.

(N.Y. Times)

According to the article, "the notes reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS."

As events would proceed, the "subjective" values of the securities dropped, and UBS requested more collateral.

The basic disagreement seems to be over UBS continuing to hit up Paramax for more collateral after a theoretical restructure of the deal was supposed to cap any further losses. But UBS continued to issue margin calls and when Paramax refused, they sued. Paramax countered for the $33.9 it lost in the swap. They say they took the word of UBS that the likelihood of a harmful downward revision was unlikely.

In looking at the capital Paramax had available, it would seem they were optimistically stoned out of their financial minds, and one cannot imagine them coming out with a gain on the transaction in any way, shape, or form. It seems their argument stands on the idea that UBS mispriced the securities and misled them at the same time. But they come off sounding slightly ridiculous.

As the article points out we can expect more of these suits piling up in the courts and the effects of unwinding these transactions will obviously be harmful to certain parties and affect the markets in ways we know not how. But it's hard to imagine if bad things can happen, that they won't, and Paramax seems to have ignored that.