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Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults

By David Evans

May 20 (Bloomberg) -- It's Friday, March 14, and hedge fund adviser Tim Backshall is trying to stave off panic. Backshall sits in the Walnut Creek, California, office of his firm, Credit Derivatives Research LLC, at a U-shaped desk dominated by five computer monitors.

Bear Stearns Cos. shares have plunged 50 percent since trading began today, and his fund manager clients, some of whom have their cash and other accounts at Bear, worry that the bank is on the verge of bankruptcy. They're unsure whether they should protect their assets by purchasing credit-default swaps, a type of insurance that's supposed to pay them face value if Bear's debt goes under.

Backshall, 37, tells them there are two rubs: The price of the swaps is skyrocketing by the minute, and the banks selling the insurance are also at risk of collapsing. If Bear goes down, he tells them, it may take other banks with it.

``There's always the danger the bank selling you the protection on Bear will fail,'' Backshall says. If that were to happen, his clients could spend millions of dollars for worthless insurance.

Investors can't tell whether the people selling the swaps -- known as counterparties -- have the money to honor their promises, Backshall says between phone calls.

``It's clearly a combination of absolute fear and investors really not knowing,'' he says.

On this day, a CDS-market meltdown doesn't happen. In a frenzy of weekend activity, the Federal Reserve and JPMorgan Chase & Co. rescue Bear Stearns from bankruptcy -- removing the need for the sellers of credit-default protection to pay up on their contracts...

The full article (it's very long) can be found here: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aePKqLJwb4Rc

As with all such pieces, it also flirts with melodrama and a touch of myopia. However, it contains some interesting anecdotes, such as this one:
The Fed was worried about the biggest players in the CDS market, Mason says. ``It was a JPMorgan bailout, not a bailout of Bear,'' he says.
...something that had to have crossed the mind of anyone who marvelled at the accounts of the way the deal was was done.