Were Hedge Funds Marks in the Credit Derivatives Meltdown?
September 21, 2009
Were hedge funds--those supposedly sophisticated investment vehicles for the high net worth crowd--themselves the target in the massive meltdown of credit derivatives that led to the financial crisis?
A recent decision in a Connecticut court is being closely watched by the U.S. Justice Department, investment banking firms and the hedge fund industry for what it reveals--and may presage--in the ongoing struggle to uncover the underlying causes of the credit crisis that began in 2007 and blew up in 2008. Under the microscope: the role played by complex derivative instruments.
In the decision, handed down Sept. 8 in Stamford Superior Court, Judge John F. Blawie ruled that Pursuit Partners, LLC, a hedge fund based there, established probable cause for its claim that Swiss banking giant UBS AG, a large player in the collateralized debt obligation (CDO) market, failed to tell Pursuit about rating agencies' plans to downgrade CDOs before selling them to Pursuit. Pursuit's $35.6 million-dollar investment was ultimately wiped out when the notes became worthless. He ordered UBS to post a $35.6 million bond in advance of trial.
CDOs are a form of credit derivative that lumps various types of debt into one bundle, ranging from the very safe to the very risky. The types of debt are known as tranches, from the French word for "slice," or "tranche."
According to the decision, Pursuit purchased the CDOs between June 26 and October 1, 2007, after repeated attempts by UBS to sell them.
"What changed between UBS's first unsuccessful pitch and its second, successful pitch was...UBS's awareness that these high-grade securities would soon turn into financial toxic waste," the judge said. And in fact, shortly after selling Pursuit the notes, UBS triggered a termination and liquidation of the notes, wiping out Pursuit's entire investment.
The court found that UBS, which worked closely with the credit rating agencies, including Moody's Corp., failed to tell Pursuit that the agencies were going to downgrade the notes before selling them to Pursuit. In fact, a series of colorful emails quoted in the decision supports the court's finding.
"Sold More Crap"
In the emails, UBS employees made reference to the purportedly investment grade securities as "crap" and "vomit." For example, on August 28, months after UBS employees knew that Moody's was going to downgrade CDOs by the end of the day, former UBS bond salesman Robert Morelli sent an email referencing the CDOs, stating that he had "sold more crap to Pursuit."
Another email from the UBS case states that "It sounds like Moody's is trying to figure out when to start downgrading, and how much damage they're going to cause--they're meeting with various investment banks."
In the sale of securities, misrepresentations are a violation of the Connecticut Uniform Securities Act, which states that a person commits fraud if the sale is made by means of any untrue statement of a material fact, or the omission of material facts.
"The use of the term 'triggerless,' which was used by UBS to entice the plaintiffs to purchase the same notes they had earlier rejected, is akin to a representation by UBS that a gun being handed to the plaintiffs is not loaded, when in fact UBS knew the gun was not only loaded, but was about to go off," the judge said in the decision.
