Last update - 00:00 15/08/2007
How to earn 300% in a global credit crunch
By Eytan Avriel
"Everything is dropping!" squealed headlines throughout the past month. Shares, bonds, government paper and even the shekel took a hammering. The feeling was that everybody was hurting, that there was nowhere to hide, nowhere to put one's money.
Yet there are arrangement funds and traders earning hundreds of percent, yes, now, by betting on the subprime and corporate credit markets.
Who are the genies of the day? One is J. Kyle Bass, manager of a hedge fund called Hayman Capital Partners. He achieved a return of 107 percent in July, and 305 percent from the start of the year. Other winners are the team managing Paulson & Co, another hedge fund that has more than $20 billion in assets. They made 76 percent in July and 303 percent from the start of the year.
Hayman and Paulson specialize in an interesting niche that has been growing exponentially: credit default swaps. It's easy. A CDS assures payment if a certain bond, named in advance, defaults. It's a kind of insurance plan.
Say you buy a CDS on drugmaker Teva, which issued some BBB-rated debt. The seller of the CDS assures you'll get the money if Teva fails to meet its bond payments. In exchange, like in any insurance plan, you pay quarterly premiums throughout the contract lifetime, which is usually five years.
The market sets the premium based on expectations that Teva, in our example, will go bankrupt, or default for some other nasty reason.
You're buying coverage. The seller is speculating, however, that Teva won't go belly-up. Then he gets his premiums and, having invested nothing, is happy.
CDS is the simplest available form of credit derivative. But make no mistake, credit derivatives are not some tiny, esoteric niche. It's a giant market thought to have been worth more than $20 trillion in 2006. Yes, trillion. And it's growing.
The entire market is a bet built on a bet. The contracts are traded at the dealing rooms of the big banks, there's no need to actually have possession of any bonds and therefore, some claim (as does investment guru Warren Buffett) that credit derivatives are "financial weapons of mass destruction".
All you need is a clear financial opinion about the credit market (say you decide that energy companies aren't about to fold) and place your bets.
That is what the hedge funds have been doing, and private investors have been doing it too.
For years, armed with powerful computers and models, major investment managers decided that the amount of bankruptcies in the world credit market won't be big after all.
They placed their bets and did well. Then came the present credit crisis and the models broke down.
The market dried up. It didn't know how to price the contracts now and the great investment outfits simply stopped trading in them. The result was huge losses for hundreds of banks and funds, and in some cases, suspension of the funds' assets.
Some lose, and some win. The winners in this last month are the ones that bet against mortgage-backed bonds.
As asset prices dived around the world, the premium that the market demanded of CDS (remember, the insurance policy) soared, and people who had read the writing on the heavily mortgaged wall raked it in.
What about our corner of the world?
Israeli investment managers don't know how, and couldn't be bothered, to protect client portfolios. Abroad, there are instruments to minimize losses on bond portfolios. But in any case, whatever the direction of the market, there's somebody making money on it. The only trick is identifying him in advance.