This is a story I caught over at Michael Panzner’s site this morning. Apparently Paramax, a hedge fund, entered into a swap arrangement with UBS based on the value of a subprime CDO back in February 2007. Under the terms of the swap, the hedge fund was required to post additional collateral with UBS if they value of the CDO fell. It did.
The suit revolves around the ‘mark-to-market’ principle. According to Paramax, UBS Managing Director said marking to market was ‘subjective,’ meaning he controlled how much UBS would mark to market, so Paramax had no need to worry about posting collateral. Needless to say, Rothman is no longer with UBS and the bonds were ‘marked to market’ down. Paramax was asked to cough up $33 million on a swap with an initial capitalization of $4.6 million. Ouch!
This is the seedy underbelly of derivatives that prompted Warren Buffett to label them financial weapons of mass destruction. I imagine we will be hearing more about this story and many such lawsuits in the coming months and years.
Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years
-Warren Buffett, 2003
He Said, She Said, Financial Armageddon, 31 May 2008
Buffett warns on investment ‘time bomb’, BBC News, 3 Mar 2003
First Comes the Swap. Then It’s the Knives, Gretchen Morgenson, New York Times, 1 June 2008