As the greatest bubble in history continues to unwind we now see the various fiduciaries turning on one another. Several weeks ago the monolines floated a trial balloon involving a split into two divisions, one municipal insurance and the other insuring defaults on structured finance. Today, the derivative plot thickens as hedge funds file lawsuits against Citigroup and Wachovia over credit default swap contracts.
In separate lawsuits filed in a New York federal court, a $58-million-asset hedge fund alleges that Citigroup and Wachovia Corp., respectively, improperly required the fund to pay out more money from insurance derivatives contracts known as “credit default swaps” amid a steep decline in the value of mortgage-backed bonds. The hedge-fund manager says he didn’t view the insurance-related trades as particularly risky and now says he feels “suckered.” Citigroup and Wachovia each say the fund’s claims are “without merit.”
Meantime, other financial players say they have been stiff-armed by trading partners when they’ve tried to cash out on profits from such insurance-related transactions. In one instance, a hedge-fund manager says he was blocked from selling out of a swap position, unless he made another credit-default swap (CDS) trade.
Of course the subject of counter party risk moves front and center while the results are somewhat discomforting.
The problem with banks and brokers buying credit protection from hedge funds is that you just don’t know when they are going to go dark, turn out the lights and say this is now the brokers’ problem,” says David Lippman, a managing director of Metropolitan West Asset Management, a bond manager in Los Angeles.
Unlike most other big players in the swaps market, hedge funds aren’t subject to heavy oversight by regulators or capital requirements. Financial firms usually guard against the risk of their hedge-fund trading partners being unable to pay by requiring they put up cash or collateral for their swap trades.
So are banks forcing hedge funds to over collateralize the CDS contracts?
One suit, filed Feb. 14, outlines a credit-default-swap agreement in which Ctigroup bought $10 million of protection against a security backed by subprime-mortgage assets from a small Florida hedge fund with just $58 million in capital. The security was a “collateralized debt obligation,” known as a CDO, or a thinly traded investment that packages pools of loans.
The fund — VCG Special Opportunities Master Fund Ltd., which is owned by an investment firm that also owns a Puerto Rican investment bank — alleges that Citigroup breached its contract after the bank demanded the fund post additional collateral. By this January, the hedge fund says, the collateral Citi sought from it nearly equaled the $10 million “notional,” or underlying, amount of the swap.
More importantly, is there really a secondary market for CDS? Some other hedge-fund managers say they’ve been bullied by securities firms when they’ve tried to cash out on profits from such positions. When one hedge-fund manager considered selling out of a credit-default swap — in which his fund bought protection on $10 million of bonds of Countrywide Financial Corp. — he says there was a condition attached by two securities firms. He says the firms — Bear Stearns Cos., which sold him the swap, and Morgan Stanley — told him they would cash him out of his profitable position, only if he would simultaneously enter into another swap-selling insurance protection on the bonds equal to his fund’s $3 million profit. Eventually, he says, his fund sold the position through Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., allowing him to book the $3 million profit.
My comments: It appears the shadow banking system is dealing with the mother of all margin calls. One creating a viscous chain reaction whereby brokers, insurers and speculators are turning on one another in order to survive the perfect financial storm.