Institutional Investor's Alpha Magazine - October 2008 - (Page 8)

Swap Frenzy T he Chicago Mercantile Exchange and Citadel Investment Group see an opening in the sprawling and unregulated credit-default-swap market, their interest fueled by a growing awareness of the enormity of the space. With this awakening, arguments against regulation have faded, and interest in some form of market standardization, at least, has risen. “Two weeks ago, market participants and other folks were screaming about potential regulations,” says Robert Claassen, a New York–based partner with global law firm Paul, Hastings, Janofsky & Walker. “Now everybody gets that they have to have a platform and wants it, and that is where the market is headed.” Enter the CME and Citadel, a $20 billion hedge fund firm, with their proposal for a central clearinghouse and electronic trading platform for the CDS market, whose size is almost too big to fathom (see “The Number,” below). The idea is to offer complete “novation” in which the clearinghouse acts as buyer to the sellers and as seller to the buyers — as a guarantor, in other words, so that neither side is a direct credit risk to the other. The CME and Citadel have set aside for themselves part of the equity in the venture and have invited major players in the CDS market to become founding members (in return for market-maker privileges). A hindrance thus far to the creation of a clearinghouse has been a lack of uniformity among CDSs. Unlike a stock or a bond, a CDS is often uniquely tailored to a particular contract. The CME/Citadel project would offer standardization around single-name products — say, swaps for a company’s bonds. Although CME/Citadel are ﬁ rst out of the gate, there is already competition. After the announcement, Atlanta-based Intercontintena lExchange said it would team up with Clearing Corp., based in Chicago, on a similar offering. The potential is gigantic. “Irrespective of who wins, you’ll see a migration toward a platform,” Claassen says. “I think it will happen very quickly because lots of folks want to get in on this.” — Robert Rosenberg Giving Is Shriveling C harities that rely on the benevolence and performance of hedge funds are feeling the pinch. The mighty Robin Hood Foundation, the largest and best-known hedge-fund-related charity, raised $56.5 million at its annual fundraiser this year, $15.5 million less than it did in 2007. Robin Hood, founded by Tudor Investment Corp.’s Paul Tudor Jones II, held the event in May, just as the credit crisis was beginning to hit its stride. The foundation also made $32.5 million through gains on hedge fund investments in 2006, the most recent figures available, but that number won’t likely be repeated anytime soon. Tax returns next spring will show exactly how badly charities have been hit; anecdotal evidence is already piling up. Some of Robin Hood’s wealth, for instance, is in Citadel Investment Group’s $9.8 billion Kensington Global Strategies Fund, which was down 22 percent this year through September. The Children’s Investment Fund Foundation, the London-based hedge fund charity affiliated with manager Christopher Hohn, counted more than $644 million in income for its ﬁscal year ended August 2007, with most of that coming from performance and management fees diverted into the charity from Hohn’s hedge fund. The $15 bil- THENUMBER redit default swaps — an unregulated, over-the-counter market fed by banks, insurance companies, pension funds and hedge funds — have been the biggest force behind the leverage of Wall Street. Collectively, CDSs had a notional value of $54.6 trillion as of June 30, according to the International Swaps and Derivatives Association, based in New York. To lend context to that number, consider that the estimated U.S. gross domestic product for 2008 is $14.3 trillion and that the Bush administration proposed a federal budget of about $3 trillion for ﬁ scal 2009. The collapse of the CDS market would make the subprime meltdown look like child’s play. Ergo, calls for regulation. A CDS, in shor t, is an insurance policy against the potential of a default on a bond. Through the sale of a swap, a lender can transfer the risk on a loan. Whoever buys a swap does the same thing, and the risk is passed along, over and over again. As the distance between borrower and lender grows, all C sense of proportion is lost. Easy credit and strong international growth fueled the explosive expansion of the CDS market, which was just $2.2 trillion in 2002. CDSs were proﬁ table, and some companies fell all over themselves to collect the quarterly premiums. Notable underwriters included investment bank Bear Stearns Cos. and insurer American International Group. Today, however, the CDS market is as frozen as the credit markets; fear of loan defaults has spread even to the debt of stalwart corporations like General Electric and Boeing. “We’ve gone from a situation where there was too much leverage to an extreme where there’s too little,” says Jeff Kushner, a London-based partner with $5 billion hedge fund ﬁrm BlueMountain Capital Management. Liquidity has evaporated, stocks have tanked, and the value of almost everything seems in question — the supposed wealth in CDSs included. So much for insurance. “Cash,” Kushner says, “is king.” — R. R. 8 • INSTITUTIONAL INVESTOR’S ALPHA • OCTOBER 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - October 2008

Institutional Investor's Alpha Magazine - October 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Process of Evolution The Good Guys: Israel's Champion Interview: Fast Lessons for Hard Times Cover Story: Industry Under Siege The New Hedge Fund Economics Good-Bye, Easy Money Caging the Shorts Strategies: Bottom Fishing Profile: Cult of Personalities Research Center: Alpha Awards: Eye of the Storm Alpha Bytes: Funneling the Chatter Unhedged: Commentary: Attention, Hedge Fund Shoppers

Institutional Investor's Alpha Magazine - October 2008

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