Hedging, Investment Bank Style!

From the New York Times comes a fascinating, although unsurprising view into the inner working of Credit Default Swaps. Apparently, at the beginning of last year, UBS found that they were going to get stuck with subprime CDO's that they didn't want to take losses on. So they looked around for a sucker to stick it to. And they found one: Stamford, Connecticut based Paramax Capital. It didn't matter that the CDO UBS wanted insured was $1.31 billion and Paramax only had $200 million. UBS just wanted to list the CDO as "insured" so that they wouldn't have to write off losses. Paramax must not have been so sure, as the deal stretched on for a couple of months. If only Paramax had gotten this gem in writing:

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.”

My note: the above quote is not a typo: "subjective" as in not objective is correct. Apparently, Mr. Rothman's promise to commit fraud on behalf of UBS sealed the deal. After all, these were AAA rated "Super Senior Tranches." After getting burned for $30 million through November, Paramax stopped paying UBS, and when UBS sued for breach of contract, Paramax countersued, claiming that due to Mr. Rothman's assurances, UBS had broken the contract by marking the CDO to market. It's so beautiful, it almost makes me want to be a lawyer.

In the investment world, this is called "Hedging."