One might think that I’d get tired of this hedge fund narrative, but I’m really into it. So come along for the ride. I’ll have some shameless speculation about wannabe City Council members in coming posts.

But get this: Forbes magazine ran a really interesting story just last week called “A Dangerous Game.” It details how obscure credit default swaps may pose a big problem for hedge funds that have been making barrels of money on them.

Here’s Forbes’ Daniel Fisher:

A credit swap is an insurance policy on a bond, often a junk bond. The fellow selling the swap-writing the policy, that is-collects a premium. If nothing goes wrong, he pockets the premium and looks like a financial genius. But if the bond defaults, the swap seller has to make good.

These credit swaps, Fisher writes, have turned into a mega market primed, potentially for a crisis.

So, who are financing the bulk of these insurance policies for the buyers of junk bonds? Hedge funds, including one that the San Diego County pension system is intimately familiar with.

And we’re not talking about Amaranth.

Again, Forbes:

Hedge funds account for 58 percent of the trading in these derivatives, says Greenwich Associates, a financial research firm. Selling protection has been a big moneymaker for funds like $23 billion (assets) D.E. Shaw and $12 billion Citadel, say market participants …

D.E. Shaw. At the very same meeting that the county pension board decided to invest $175 million in Amaranth – only to later watch most of it disappear – it invested another $175 million in the hedge fund D.E. Shaw.

At the little workshop last week, county pension officials made the point over and over again that their hedge fund investments shouldn’t be considered separate pieces of their investment pie. In fact, they said, using hedge funds was just a different way to invest in stocks.

In a recent report in the North County Times, one board member of the county pension system, Laura DeMarco, described the hedge fund investment like this:

Demarco said the 11 hedge funds that the association invested in were “overlays” that were designed to work with other investments in stocks — the Standard & Poor’s 500.

Demarco said the hedge funds were spread like “icing” over the S&P 500 cake, and were actually designed to carry less risk than the stocks themselves.

But Forbes claims D.E. Shaw is making a lot of money selling insurance to people who purchase junk bonds.

What cake, exactly, is this hedge fund icing?


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