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How Derivatives Traders Can Also Be Heroes

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by Yves Smith and Felix Salmon
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Jun 07 2007 12:00am EDT

How Derivatives Traders Can Also Be Heroes

What's the opposite of a vulture? Vulture funds, in popular imagination (if not in reality), buy up debt on the cheap and then profit from the distress of others by trying to maximise the amount of money they can extract from their debtors. But what would you call someone who buys up debt on the cheap and then tries to profit by helping out the debtors as much as possible? If you're a normal person, you might call such a trader a hero. If you're hedge-fund manager John Paulson of Paulson & Co, however, you accuse people of market manipulation.

The problem seems to be that Bear Stearns has sold credit protection on subprime-backed securities to Paulson. If Bear does nothing, it has to pay out on its insurance contract. But if it buys up the underlying mortgages and restructures them so that the homeowners don't end up defaulting, then Paulson gets nothing.

That's a great trade. Good for Bear. Paulson just got out-traded, is all.

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