Beating Up on the Little Guy

I don't typically turn to the pages of the Wall Street Journal for a laugh, but today they posted a good bit on Wall Street's recent dealings surrounding credit default swaps on CDOs and other subprime-related junk (a credit default swap acts like insurance on a bond; the seller of the contract receives streams of payments from the buyer, who in return receives insurance against future losses).

Hedge funds are apparently getting bullied by the big banks in a myriad of ways. Some of the details are a bit sketchy, so I'm going to take a stab at translating the tale of woe in the last paragraph as I understand it, in the spirit of the excellent Subprime Primer (no relation):

Hedge fund: Hi there. I'd like to cash out this extremely lucrative position.

Investment bank: Great, I've got just the deal for you. For the month of March, we are offering customers just like you the chance to sell us insurance on a bag of toxic waste!

Hedge fund: I'm not interested, I think I'd rather just make a clean exit.

Investment bank: I'm sorry, did I say this is optional?

Hedge fund: What do you mean? I just want my $3 million!

Investment bank: It's a deal, then- that's the kind of talk I like to hear! Perhaps I can also interest you in a product that I believe suits your needs perfectly: we have this ticking time bomb in a black box in a shed that's located somewhere in...well, no one knows exactly where it is. But we know that we need insurance on it, and we know that you've got some cash on hand.

The unnamed hedge fund in question turned to Goldman Sachs to close out its $3 million position after getting this kind of schtick from Morgan Stanley and Bear Stearns. The article also reported that Citigroup and Wachovia forced two hedge funds to post collateral in amounts that nearly equaled the underlying value of the credit default swap that they had sold as protection for the banks.

Consider these positions alongside one another: investment banks are bullying hedge funds into selling insurance on faltering bonds at the same time that they are getting extremely nervous about the ability of hedge funds to make good on their promises. This does not portend a bright future for Wall Street.

So there you have it, more evidence that financial markets have attained new heights of tragicomic irrationality. If there weren't such dire consequences for the economy, it would be downright amusing to watch these Wall Street folks get slapped upside the head by all sorts of unpredictable, invisible hands.

One important observation that the article makes is that hedge funds are a huge player in the credit default swap market:

Bond insurers in recent years represented a small but psychologically important part of the credit-derivative market, comprising 8% of the sellers of credit protection, according to estimates from the British Bankers Association.

But hedge funds are an even bigger player in this arena. Hedge funds provided roughly one-third of trading volume in all credit derivatives in 2006 -- up tenfold from 2000, the BBA says. And hedge funds accounted for 60% in credit-default-swap trading in high-grade debt and 80% in low-grade debt in the 12 months ending April 2007, Greenwich Associates estimates.

First it was the SIVs, next it was the bond insurers. If the bond insurer problem is contained for the time being, the hedge funds look to be next up. It's hard to say whether a systemic financial breakdown beyond what we've seen so far is in the offing, but if so hedge funds will certainly play a starring role. If not, it looks like they are still bound for a dismal year.