Last week, there were several articles about the ongoing lawsuit between UBS (NYSE:UBS), the Swiss investment bank, and Parmax Capital, a small hedge fund at Stamford, CT. You can read them here from The International Herald Tribune, and from The New York Times here.
This credit default swap [CDS] deal started back in May 2007 when UBS asked Paramax to provide insurance protection to a subprime CDO underwritten by UBS. This CDO had a notional amount of $1.31B and was rated AAA by both S&P and Moody's at that time.
The strange thing here is Paramax is only a small hedge fund with just $200 million in capital. Why would UBS ask an undercapitalized fund to insure its CDO with less than 1/6 of its notional amount? It is like a millionaire asking his homeless brother to insure his multi-million house; the purpose was obviously not about insurance.
It would have been more understandable if this CDS deal was conducted with AIG, which is a well-established insurance firm with large capital base sufficiently and able to cover this kind of claim, even though this has caused AIG big losses in recent quarters.
Even UBS is not commenting on this legal battle. Their motivation for this CDS deal might be one or both of the two reasons I wrote about in a previous article "Why Wall St. Needed Credit Default Swaps?":
1) They use this deal to cover the deteriorating value of their underlying CDO temporarily, so they don't need to write it off right away, and can point to this CDS "insurance".
2) They conducted this CDS deal in order to justify a negative basis trade on the underlying CDO to realize its "profit" for next 10 years in their books last year. Maybe both 1) and 2).
Another interesting thing about this deal is UBS would only pay Paramax 0.155% of the $1.31B notes annually in exchange for its "protection". This premium of $2M per year for $1.31B seems low even for a AAA rated bond, especially in May 2007, when the subprime mortgage crisis already began and was in the headlines, and subprime was exactly the underlying asset of this CDO. Apparently Paramax was being used and the low premium was a rip-off of this small hedge fund.
Paramax actually didn't feel very comfortable about this deal initially. But they received assurance from the UBS managing director who was responsible for mark-to-market, that, "UBS sets its marks on the basis of 'subjective' (this is not a typo: not 'objective') evaluations that permitted it to keep market fluctuations from impacting its marks", and he "could justify 'subjective' marks on the Paramax swap because of the unique and bespoke nature of the deal." I am wondering what the unique and bespoke nature was in his mind at that time? And he contended that even if significant defaults arose, UBS's marking of the position "might not be as bad as you'd first think". Whatever that means, but obviously all these statements and promises convinced Paramax to sign off on this CDS deal.
As you might have guessed, this CDO went sour right away. Paramax paid $4.6M collateral initially. Only 6 weeks later, the 1st margin call of $2.36M arrived. Talk about perfect timing by UBS. Then in early August, the 2nd margin call of $12.7M came, then the 3rd margin call of $14M, with total margin calls quickly reaching almost $30M in late August, 6 times Paramax's initial collateral, only 3 months after signing the contract.
We all know this can't go on forever. Then came the last big "straw" that broke Paramax's back. UBS issued another margin call in early November, this time, seeing no end to this, Paramax threw in the towel and refused to pay, and UBS didn't keep its end of the bargain and its promise to "set marks subjectively" and sued. This over the counter [OTC] CDS deal has finally become public.
UBS is a very sophisticated bank; there is no chance that they were not aware of the counterparty risk here by engaging a small undercapitalized hedge fund. It is common sense, and UBS doesn't need to build computer models and run tons of Monte Carlo simulations to figure it out. Even though the real purpose of this deal is unknown and probably may never be known, this lawsuit will become a unique, important and well-publicized test ground and legal precedent for all future CDS litigations, which are looming and growing exponentially every day. This is definitely not the original intention, and probably not the desired consequence, for UBS when they conducted this deal.
This kind of CDS deal also puts a lot of doubts about setting up a separate clearing house, platform and market for OTC CDS contracts, a popular topic these days. If there is a platform, will this clearing house cover Parmax's loss by 1) using taxpayer's money from the Fed or Treasury Dept? or 2) using funds provided by an investment bank consortium including UBS, which means investment banks have to bite the bullet and absorb these kind of losses by themselves?
I am sure this legal battle will be watched closely by all parties involved in the CDS market. Eventually it will give us an idea about how bad the current mess the $62 trillion and growing OTC derivative market will be.
