Paramax vs. UBS: "CDO Insurance Was Just A Joke Anyway"

Reviewing some news releases from the past few days, we just noticed this piece on the Paramax monoline insurer vs. UBS spat. The case concerns whether Paramax should have to pay out on its obligations for UBS subprime mortgage CDOs that, well, did what we know now subprime mortgage CDOs do.

Many monolines are now involved in lawsuits over whether the characteristics of the assets they were insuring were accurately represented to them. But what is interesting to us is that this suit is a little different: key to Paramax's defense, it seems, is the claim that the insurance was never intended to be "real" anyway. Sounds fantastic, but here is the quote:

Paramax claims that, from the beginning, the UBS hedge was cosmetic. In May 2007, when the original agreement was signed, the terms were a fraction of the market rate. Also, Paramax had only $200m under management and its agreements with its own investors limited it to commit no more than $40m to any single deal. Thus, it could never compensate UBS fully for any meaningful loss in value of the $1.3bn UBS was trying to insure, it claims.

Paramax also claims that UBS told it that the bank would employ “subjective valuation methodologies” that meant it would not record any loss in value that could trigger calls for additional margin from Paramax. (Because credit derivatives contracts are individually tailored agreements rather than standardised documents, in fact there is some discretion in how firms value such deals.) Paramax also claims that UBS promised that if the lender needed a “real” hedge, it would tear up the agreement.

In other words, the insurance arrangement itself was a joke, or pessimistically, a scam -- fraud. While Paramax is relying on this "just foolin'" argument as a defense, we wonder what the outside world of investors (in both the banks and monolines) will think of this kind of revelation. We suspect this sort of sly deal was widespread... systemic, one might say.

--apk